EUROPEAN COMMISSION Brussels, 22.2.2017 SWD(2017) 71 final COMMISSION STAFF WORKING DOCUMENT Country Report Germany 2017

Including an In-Depth Review on the prevention and correction of macroeconomic

imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP

2017 European Semester: Assessment of progress on structural reforms,

prevention and correction of macroeconomic imbalances, and results of in-depth reviews

under Regulation (EU) No 1176/2011



{COM(2017) 90 final}

{SWD(2017) 67 final to SWD(2017) 93 final}





Contents Executive summary1 1.Economic situation and outlook4 2.Progress with country-specific recommendations12 3.Summary of the main findings from the MIP in-depth review15 4.Reform priorities21 4.1.Public finances, fiscal frameworks and taxation* 21 4.2.Financial sector25 4.3.Labour market, education and social policies30 4.4.Investment37 4.5.Sectoral policies45 4.6.Public administration51 A.Overview table53 B.MIP Scoreboard60 C.Standard tables61 References66 LIST OF Tables 1.1.External balance of goods and services by type of activity9

1.2.Import content of outputs/products9 1.3.Key economic, financial and social indicators – Germany11 2.1.Summary table on 2016 CSR assessment13 3.1.MIP assessment matrix – Germany20 4.1.1.Budgetary projections for Germany compared to European and national deficit ceilings21 4.2.1.Financial soundness indicators, all banks in Germany25 4.5.1.Broadband availability (2016)50 B.1.The MIP Scoreboard for Germany60 C.1.Financial market indicators61 C.2.Labour market and social indicators62 C.3.Labour market and social indicators (continued)63 C.4.Product market performance and policy indicators64 C.5.Green growth65 LIST OF Graphs 1.1.Demand components of GDP growth4 1.2.Investment in machinery and equipment4 1.3.Investment in other assets5 1.4.Employees, hours worked and hours worked per employee (total economy)5 1.5.Contributions to headline inflation6

1.6.Sectoral net lending and current account balance7 1.7.Determinants of household disposable income7 1.8.Current account and component balances8 1.9.External balance of goods and services8 1.10.Goods balance vis-à-vis the rest of the euro area9 1.11.Fiscal and debt developments10 4.2.1.House price trends in Germany26 4.2.2.Price-to-income and price-to-rent ratios27 4.2.3.Rents versus house prices27 4.2.4.Building permits and construction work completed for dwellings28 4.2.5.Structure of housing investment29 4.3.1.Labour force indicators30 4.3.2.Employment rate difference between tertiary educated nationals and third country citizens (2015)31 4.3.3.PISA performance in science (2015)35 4.4.1.Investment gap with respect to the euro area37 4.4.2.Determinants of the savings-investment balance of non-financial corporations37 4.4.3.Net capital stock by type of economic activity38 4.5.1.Business enterprise expenditure on R&D by economic activity (2014)45 4.5.2.Venture capital investments in German companies46 4.5.3.Restrictiveness indicator (2016)47

4.5.4.Trends in track access charges48 4.5.5.Share of fibre connections as a proportion of total fixed broadband (2015)50 LIST OF Boxes 2.1.Contribution of the EU budget to structural change14 3.1.Euro area spillovers18 4.1.1.Scenarios for labour taxation reforms: distributional and fiscal effects24 4.3.1.Refugee integration32 4.4.1.Investment challenges and reforms in Germany39 4.4.2.Reducing the debt bias and improving the investment-friendliness of corporate taxation41 4.4.3.Main elements of the reform of federal fiscal relations44 4.6.1.Selected highlights52 Executive summary This report assesses Germany’s economy in the light of the European Commission’s Annual Growth Survey published on 16 November 2016. In the survey the Commission calls on EU Member States to redouble their efforts on the three elements of the virtuous triangle of economic policy – boosting investment, pursuing structural reforms and ensuring responsible fiscal policies. In so doing, Member States should focus on enhancing social fairness to deliver more inclusive growth. At the same time, the Commission published the Alert Mechanism Report (AMR) that initiated the sixth round of the macroeconomic imbalance procedure. The in-depth review, which the 2017 AMR concluded should be undertaken for the German economy, is presented in this report. Economic growth was robust in 2014-2016, driven by domestic demand. Real GDP growth stood at 1.7 % in 2015 and 1.9 % in 2016. Private consumption in 2016 grew for the second time in a row by 2.0 %, supported by a substantial rise in real disposable income. The unemployment rate fell to a post-reunification low of 3.9 % by the fourth quarter of 2016, despite a growing workforce. Business investment activity has been uneven and is expected to pick up only moderately in the near future. Germany’s investment ratio has remained at around 20 % of GDP. While housing investment has been on an upward trend since the crisis, non-residential construction investment has stayed relatively flat. Importantly, investment in machinery and equipment has remained restrained and has still not caught up with pre-crisis levels. This is despite supportive financing conditions, strong corporate profits and continued export growth that traditionally drives this type of investment. Overall, this subdued investment growth has resulted a much slower expansion of the capital stock and a relatively low contribution of capital accumulation to potential growth compared with other large advanced economies. It appears likely that Germany’s economic growth momentum will be maintained. With energy prices no longer declining, real household consumption is forecast to slow down somewhat, but to remain relatively strong owing to rising employment and real labour income. The latter will also be boosted by an increase in the minimum wage in 2017. Financing conditions are expected to remain supportive of investment. Bolstered by domestic demand, GDP is expected to grow by 1.6 % in 2017 – slowing significantly on account of a fall in the number of working days – and by 1.8 % in 2018. However, major factors behind restrained domestic investment are still in place, which have increased the savings-investment imbalance and contributed to the current account surplus. These relate mainly to continued subdued growth in domestic and EU markets and the higher rates of return for capacity expansion abroad. A high degree of uncertainty, including with regard to technological change, adds to companies’ reticence to invest. Obstacles to more dynamic private investment also result from restrictions in the services sector, some unfavourable corporate taxation features and delayed investment in transport, energy and telecommunications infrastructure. Recent efforts to facilitate and stimulate public investment, notably at municipal level, have so far had limited effects. Public finances remain in a sound position. General government budget surpluses were recorded in 2015 and 2016. The budget is expected to remain in surplus in headline and structural terms in 2017 and 2018, and the gross debt-to-GDP ratio is set to decrease further.

Due to its economic importance and strong integration in the value chains in the EU, Germany is a source of potential spillovers to other Member States. Further strengthened domestic demand, including higher public investment, would increase Germany’s actual and potential growth, and would also stimulate demand and GDP growth in other EU countries, including those with deleveraging needs. It would have a positive impact on average inflation, not least in the context of the current expansionary monetary policy. Overall, Germany has made limited progress in addressing the 2016 country-specific recommendations. Some progress has been made towards achieving a sustainable upward trend in public investment. This is notably done by increased infrastructure investment and by improving the design of federal fiscal relations in support of higher and accelerated public investment at all levels of government. At the same time, progress has remained limited on increasing public expenditure on education, research and innovation. Limited progress has also been made in reducing inefficiencies in the tax system, modernising tax administration, and stimulating competition in the services sector. Some progress has been made in reviewing the regulatory framework for venture capital. Limited progress has been made in increasing incentives for later retirement and reducing the high tax wedge for low-wage earners. No progress has been made in reducing disincentives to work for second earners and facilitating the transition from mini-jobs to standard employment. Regarding progress in reaching the national targets under the Europe 2020 strategy, Germany is performing well on the employment rate, reducing early school leaving and poverty, increasing tertiary education attainment, investment in research and development (R&D), and the share of renewable energy. On the other hand, uncertainty remains in terms of achieving greenhouse gas emissions and energy efficiency targets. The main findings of the in-depth review contained in this report, and the related policy challenges, are as follows: The persistently high current account surplus grew further in 2016 and is projected to remain above 8 % of GDP until 2018. The German current account and trade surpluses make up about three quarters of the euro area surpluses and are the highest among large advanced economies. Falling prices of oil and other raw materials and the depreciation of the euro explain a substantial part of this increase in 2015-2016. Yet, the high level and persistence of the surpluses reflect an excess of savings over investment relating to a number of structural, regulatory and fiscal factors. Private domestic investment continues to face headwinds. These are owing to sluggish growth in domestic markets, increased geopolitical uncertainty and inefficiencies in corporate taxation system and business environment. By contrast, private consumption is at the root of the ongoing shift towards more domestic demand-driven growth. The trade and current account surpluses are expected to remain at historically high levels and to fall only gradually over the medium term as domestic demand strengthens further. Germany is emerging only slowly from a decade of weak public investment following the post-unification boom. Recent measures aimed at increasing infrastructure investment have not yet resulted in a clear upward trend in public investment as a proportion of GDP. Moreover, net investment remained negative at municipal level until 2015. The favourable budgetary position indicates available fiscal space, inter alia for providing additional funds – in addition to what has been provided so far – to increase public investment at all levels of government. Taxation still tends to impede private consumption and investment. Household income and consumption continue to be restrained by the high tax wedge on labour, especially for low-wage earners. Measures taken to adjust personal income tax rates and to compensate for fiscal drag can be expected to have only a limited impact on lowering the tax wedge. Corporate taxation continues to be high overall, and there is still inefficiency in tax administration. Various challenges will impact on the economy’s future growth potential. The expected impact of the ageing society, shifts in technology, in particular the digital revolution, and – partially policy driven – demand change, including in the energy and transport sector, have major implications for the economy’s production capacity and productivity. Tackling these challenges is a prerequisite to maintain Germany’s high living standards and to cope with increasing globalisation and digitisation. In the financial sector, improving efficiency and profitability remains the biggest challenge for German banks, which is further accentuated by the digital transformation of financial services. Although the German housing market is currently buoyant, available data suggests that it does not constitute a risk to financial stability. Venture capital investment has increased, but the market is still underdeveloped by international standards. The strong labour market performance has only been partly mirrored in full-time employment and wage growth. Employment has continued to rise and unemployment has fallen to historically low levels. This reflects the supportive economic situation, but also results from a well-performing apprenticeship system, company-internal flexibility and a culture of co-determination. However, the increase in employment has been partly due to an increase of part-time work, in particular among women. The labour market potential of certain groups remains underused and disincentives to work remain in place, particularly for second earners. Challenges for the labour market, social policy and the education system in the medium to long term result from a shrinking and ageing population that may lead to labour and skills shortages. Wage growth remains moderate. Private investment appears particularly restrained in certain sectors, pointing to specific investment barriers. While large technology-intensive corporations are investing strongly in equipment and knowledge, the services sector and small and-medium-sized enterprises (SMEs) are lagging behind compared to other advanced economies. There is also evidence that the share of SMEs investing in R&D has been gradually declining in recent years. A high level of regulatory restrictiveness in the services sector, notably in business services, affects business dynamics and investment in this sector, but also has repercussions on the manufacturing industry. Other key economic issues analysed in this report which point to particular challenges facing Germany’s economy are as follows: Not all members of society have benefited equally from the overall positive economic and labour market developments of the last few years. After a period of increases, income inequality moderated only recently. Moreover, the good labour market performance of recent years has not led to a decline in the risk of poverty. Although severe material deprivation has remained broadly stable, various indicators of relative poverty and social exclusion are on the increase. Pension adequacy is also expected to further deteriorate. Immigration in recent years is both a key challenge and an opportunity. Germany has made considerable efforts to accommodate asylum seekers and integrate refugees. However, people with a migrant background generally continue to be less integrated in the labour market. The employment rate of non-EU nationals is only at the EU average and significantly below the employment rate of German nationals. There are still institutional barriers to the recognition of qualifications, and the achievement gap in education between immigrants and non-immigrants remains wide. On the other hand, immigrants are currently setting up almost half of all new businesses. Sizeable investment is still needed to adapt electricity networks to the increasing share of renewable energy. Planned investment in internal electricity infrastructure is significantly delayed, owing partly to public opposition. The political decision in favour of underground cables may accelerate investment, though at a considerably higher cost. Covering the rising level of weather-dependent renewable energy power flows also hinges on significant investment in electricity distribution networks. Moreover, the lack of sufficient cross-border interconnections is still constraining the trade in electricity with neighbouring countries and impairing the security of supply. There are barriers to reaping the full benefits of digitisation. Germany is lagging behind in the availability of high-speed broadband connections, in particular in semiurban and rural regions. Computers usage by young Germans is comparatively low and many schools lack broadband access. Performance in digital public services is below average. 1. Economic situation and outlook GDP growth Economic growth strengthened further in 2016. GDP increased by 1.9 % from 1.7 % in 2015. This is the highest growth rate since 2011 and is about 0.5 pps above the long-term average. Growth was mainly driven by private consumption (Graph 1.1), which for the second time in a row increased strongly at 2 % or 1 pp. above its long-term growth. Public consumption and investment accelerated markedly, driven importantly, but not exclusively, by expenditure on refugees. Private investment growth was mainly driven by very dynamic housing investment.

Graph 1.1:Demand components of GDP growth Source: European Commission Economic growth momentum is expected to be maintained, though export and investment prospects are subject to sizeable downside risks. With energy prices no longer declining, real household consumption is forecast to slow down somewhat, but to remain relatively strong thanks to the continued rise in employment and real labour incomes. The latter will also be supported by an increase in the minimum wage next year. Financing conditions are expected to remain supportive of investment. Further boosted by domestic demand, the growth rate is expected to be 1.6 % for 2017 – slowing largely on account of fewer work days – and 1.8 % for 2018. All in all, the output gap has essentially closed and the economy is expected to operate at close to full capacity in 2017 and 2018. However, uncertainty on the outcome of the ‘Brexit’ negotiations, the trade policy stance of the new US administration, cyclical trends in the Chinese economy and geopolitical risks could weigh on foreign trade and investment prospects. On the other hand, the depreciating euro will improve German price competitiveness in non-EU markets. Graph 1.2:Investment in machinery and equipment Source: European Commission Investment Business and infrastructure investment activity remains subdued and is likely to increase only moderately in the near future. Machinery and equipment investment has not yet recovered from the setback during the financial market crisis of 2008-2009. It suffered a much more pronounced setback than after the bursting of the internet bubble and has been recovering much more slowly, with the sum of the two setbacks corresponding to about 2 % of GDP (Graph 1.2). Non-residential construction investment has been largely stagnant for more than a decade (Graph 1.3). This possibly still rests on the massive post-unification investment effort, but also gradually exposes capacity shortages in essential infrastructure and negative net investment at municipal level (see Section 4.4) (European Commission, 2014). Graph 1.3:Investment in other assets Source: European Commission Despite increases in 2015 and 2016, public investment is still relatively low. Following an increase of 4.9 % in 2015, public investment strengthened further in 2016, rising to about 6.9 % in nominal and 5.8 % in real terms. This was driven by strong growth in machinery and equipment investment and construction investment. However, at 2.2 % of GDP in 2016, overall public investment has remained largely constant in recent years and is still relatively low compared with the euro area (2.8 % of GDP without Germany), despite a downward euro area trend since 2009. These developments may be partly explained by various factors that are country-specific to Germany (see Section 4.4). A public investment backlog persists in particular at municipal level, where net investment remained negative in 2015. Labour market Unemployment has again reached record lows and employment record highs, though this is not reflected to the same extent in full-time employment. The unemployment rate declined to a historic low of 3.9 % by the fourth quarter of 2016 (down from 4.6 % in 2015), whereas the employment rate of the population aged 20-64 increased to 78.9 % by the third quarter of 2016. However, since the crisis employment has increased more strongly than total hours worked, and hours worked per employee have been on a downward trend for some time (Graph 1.4). Graph 1.4:Employees, hours worked and hours worked per employee (total economy) Source: Destatis Wage developments have benefited only to a limited extent from the strong labour market performance. Due to undershooting inflation, real wages ( ) increased by 1.9 % in 2016. This is welcome in view of the strong labour market performance and the need to strengthen domestic sources of growth, while the social partners do not appear to be making full use of the existing scope for sustained wage increases (European Commission, 2016a). The population in Germany has been increasing in recent years, with immigration peaking in 2015. While the population in Germany shrank between 2002 and 2010, this trend has reversed over the last six years, with cumulative positive net immigration of 2.9 million people. In 2015, 2.1 million people migrated to Germany, while 1 million emigrated resulting in a net migration of 1.1 million people (1.4 % of total population), the highest annual inflow since the 1950s. Following the EU-Turkey agreement and the closing of the Balkans-route, the inflow of asylum seekers fell sharply from around 890 000 in 2015 to around 280 000 in 2016 (Federal Ministry of the Interior, 2016). Social developments Despite overall positive economic and labour market developments in the last few years, income inequality has increased and moderated only recently, while wealth inequality remains among the highest in the euro area. Income inequality according to the S80 /S20 indicator ( ) rose until 2007 to 4.8 in the wake of an unfavourable labour market and the increasing weight of capital income compared to labour income. It fell to 4.3 in 2012 and rose again to 5.1 in 2014. While remaining slightly below the EU average, this was the highest recorded level. The same pattern can be observed with the Gini index. ( ) The larger low-wage sector has created new employment possibilities but also tends to accentuate wage inequality and in-work poverty. Low upward mobility due to a relatively strong link between socioeconomic background and education outcomes also contributes to inequality (Section 4.3). In 2015, inequality according to the S80 /S20 indicator fell again to 4.8, which however remains above the long-term average. While both the distribution of wealth and the composition of household wealth have remained stable over time, wealth is distributed relatively unequally compared to other European countries, owing partly to low rates of home ownership (Deutsche Bundesbank, 2016a). Net wealth inequality was among the highest in the EU (European Central Bank, 2016a). . In addition, the effectiveness of redistribution policies in reducing both inequality and poverty has declined. In 2008-2014, Germany stood out for large poverty-increasing policy effects, reflecting the fact that levels of means-tested benefits fell in real terms and relative to market income growth (European Commission, 2016b). A number of previous changes in taxation and social contributions may also have played a role in reducing the effectiveness of redistribution policies. The suspension of the wealth tax in 1997, the reduction in the top income tax rate from 53 % in 2000 to 42 % in 2004, the flat rate taxation of capital gains since 2009 and the increases in social contributions since the beginning of the 1990s have all contributed to making the tax system less progressive and possibly to rising income inequality (European Commission, 2014). Inflation Core and headline inflation are set to pick up. Headline inflation has shot up to 1.7 % y-o-y in December on the back of a base effect and rising energy prices (Graph 1.5). After averaging 1 % over most of 2015-2016 core inflation increased to 1.5 % in December 2016. With the increase in oil prices, headline inflation is projected to pick up in 2017 (1.9 %). Firming domestic demand and wage growth should ensure that core inflation rises in both 2017 and 2018. Graph 1.5:Contributions to headline inflation Source: European Commission Sectoral balances The current account surplus has increased further in 2015 and 2016, reaching a new historical high of 8.7 % of GDP. When analysed from the perspective of domestic economy, further current account widening was driven by the excess of national savings to investment (Graph 1.6). Although private borrowing picked up significantly in 2015, it remains below GDP growth and the trend of net financial asset accumulation by the private sector has continued. Nominal corporate investment fell in 2015 and most likely also fell in 2016. Meanwhile, corporate savings increased as a share of GDP. As a result, corporations, whose indebtedness is, on aggregate, already the lowest in the euro area, continued deleveraging. This was the biggest contributing factor to the widening of the savings surplus. The household savings rate rose further in 2015 and is estimated at 17.1 % for 2016, one of the highest household savings rates in the euro area (average at 12.5 % in 2015). In 2015, household investment growth continued to lag behind savings growth, while in 2016 housing investment picked up and the net lending position of households weakened marginally.

Graph 1.6:Sectoral net lending and current account balance Source: European Commission The deleveraging of non-financial corporations combined with investment restraint is a key driver of economy-wide excess savings. Companies have been raising their equity ratio and striving to rebuild their financial autonomy by scaling down debt and squeezing dividend pay-outs to owners (see Section 4.4). This has dented household incomes and the private consumption share of GDP, while the percentage of household savings in GDP has remained stable. At the same time, the GDP share of investment by nonfinancial corporations has remained low for over a decade despite the accumulation of financial buffers and favourable financing conditions. Since the swift improvement in 2010-2011, the assessment of the investment climate by enterprises has generally been deteriorating, especially demand and financing factors. As a result, original investment plans have been carried out only partially, leaving earmarked funding unused. The consumption share of GDP remains relatively low as the household sector has tended to stabilise saving. The share of labour income has increased since 2011, but so have the shares of income tax and social security deductions (Graph 1.7). The share of property income has been falling as a result of less generous dividend pay-outs by corporations. The saving rate has nevertheless remained stable, while consumption has declined in parallel with household disposable income as a proportion of GDP. This has not prevented an increase in real consumption as purchasing power was boosted by low inflation. Even so, the consumption share of GDP (53.5% in 2016) remains low from an historical perspective. Graph 1.7:Determinants of household disposable income Source: European Commission Graph 1.8:Current account and component balances Source: Bundesbank, European Commission External position The current account surplus has edged up further from a historically high level and is expected to decline only slowly in the coming years. In 2016, it increased to 8.7 % of GDP, from 8.5 % in 2015 and 7.5 % in 2014. The trade surplus is behind the level and dynamics of the current account surplus (Graph 1.8). It has increased to 8.9 %, from 8.7 % in 2015 and 7.7 % in 2014. Terms-of-trade effects, largely due to cheaper energy and other commodity prices, have accounted almost entirely ( ) for the widening of the trade balance by 2 pps of GDP since 2013 (Graph 1.9). Over the course of 2017, exports are forecast to pick up again as foreign demand is expected to increase, if significant downside risks are disregarded. Improved income expectations should spur domestic demand and import growth. Overall, net trade is therefore expected to detract slightly from growth over this year and next. The positive terms-of-trade effects from low oil prices are also set to fade. As a result, Germany’s trade surplus could start to narrow. Nevertheless, the current account surplus is expected to remain very high and to decline only gradually over the medium term. Graph 1.9:External balance of goods and services Source: European Commission The narrowing of the current account surplus with respect to rest of the euro area observed since 2008 halted and started to reverse in 2014. The reversal mostly affected the Netherlands, Belgium and Luxembourg and was probably linked to price effects in the trade in petroleum products and other fuels (Graph 1.10). The countries with deleveraging pressures like Italy, Spain and Portugal have been less affected by this reversal, as imports originating from these countries have grown roughly in line with German GDP. In the first three quarters of 2016, the year-on-year real growth of imports originating from the euro area was higher than that of imports from outside the EU. Germany’s widening current account surplus in recent years has been driven by surpluses vis-à-vis non-euro area countries. Although widening again since 2014, the share of the surplus in relation to the rest of euro area has remained roughly stable at 20 % of the total in 2013-2016. In the pre-crisis period 2005-2009, this share averaged 60 %. Graph 1.10:Goods balance vis-à-vis the rest of the euro area Source: Bundesbank, European Commission Germany remains the most open large economy in the world with respect to both exports and imports. German exports of goods correspond to about 47 % of its GDP. This compares to 44 % for the EU, 46 % for the euro area, about 30 % for France, Spain, Italy, the UK or Russia and as little as 18 % for Japan and 12 % for the US. However, what holds for exports also holds – albeit to a lesser extent – for imports, which correspond to about 40 % of GDP for Germany, the EU and the euro area, about 30 % for Spain, France, Italy and the UK, 21 % for Russia, 18 % for Japan and 15 % for the US. German industries have consistently maintained positive external balances of goods and services. In manufacturing, for instance, the share of exported output rose from 47 to 56 % between 2005 and 2014, which is about 10 pps more than for the economy as a whole. The key sectors driving this surplus are machine-building, accounting for almost half of the current account surplus, and chemicals (Table 1.1). Market services have also become increasingly internationalised. Germany’s integration in the global value chain is a structural feature of its economy which is also showing up in the export content of imports. Together with the US and China, Germany is one of the few economies whose imported final products contain more than 10 % domestic input, due to their key position in the global technology chains. Nevertheless, the share of import content in gross output and domestic demand has been stable or rising across all major sectors and demand categories over the last decade (Table 1.2). Table 1.1:External balance of goods and services by type of activity Source: Stehrer et al., 2016, European Commission Table 1.2:Import content of outputs/products Source: Stehrer et al., 2016, European Commission Public finances The fiscal situation remains favourable and fiscal space available. The general government budget surplus amounted to 0.6 % of gross domestic product in 2016. In 2017-2018, total revenue is expected to stay flat as a percentage of GDP, although increases in the minimum personal income tax allowance and child allowances and an adjustment of income tax brackets (to offset the impact of fiscal drag) will weigh on revenue growth. At the same time, expenditure continues to benefit from declining interest expenditure. Real public investment is expected to grow slightly as a result of additional funds earmarked for infrastructure investment and social housing. Overall, the headline balance, though decreasing, is expected to remain in surplus over the forecast period. The structural surplus is projected at around 0.4 % of GDP in 2017 and 0.3 % of GDP in 2018, hence about 1 percentage point of GDP above the medium-term objective of a structural deficit of 0.5 % of GDP. The gross debt-to-GDP ratio is set to fall from 71.2 % in 2015 to around 63 % in 2018 (Graph 1.11). Graph 1.11:Fiscal and debt developments Source: European Commission

Table 1.3:Key economic, financial and social indicators – Germany Source: European Commission, ECB 2. Progress with country-specific recommendations Progress with the implementation of the recommendations addressed to Germany in 2016 has to be seen in a longer term perspective since the introduction of the European Semester in 2011. ( ) In recent years, the Federal Government has taken a number of measures to strengthen its own investment spending and to support public investment at the level of federal states and municipalities. However, this has not yet produced a clear upward trend in the public investment-to-GDP ratio at general government level (see Section 4.4). Public spending on education and R&D as a proportion of GDP at general government level has remained stable in recent years. Multiannual progress has been limited in other policy fields. Reform efforts to improve the efficiency of the tax system and modernise tax administration have remained limited in scope, and no measures have yet been taken to comprehensively review corporate taxation and the local trade tax. To date, there is no strategy to substantially modernise the regulated professions and to strengthen competition in the services sector beyond minor adjustments. First steps have been taken to improve incentives to retire later after the pension reform 2014 facilitated earlier retirement. Measures to reduce the high tax wedge for low-wage earners have been limited to the regular adjustments of the minimum personal income tax allowances and tax rates to account for changes in the subsistence level or the impact of fiscal drag. To date, no initiatives have been taken regarding second earners and mini-jobs, in particular with a view to incentivising women to take up full-time jobs. Overall, Germany has made limited progress in addressing the 2016 country-specific recommendations (CSRs). ( ) Some progress has been made in increasing public investment in line with CSR 1. The Federal Government has further relieved federal states and municipalities of social expenditure, and a reform of federal fiscal relations has been agreed (Box 4.4.3). At the same time, education and research expenditure as a proportion of GDP has remained largely stable in recent years. Only limited progress has been made on CSRs 2 and 3. While some simplification in certain areas of taxation and better conditions for venture capital can be expected, there have been no initiatives to review business taxation. Moreover, a strategy to substantially improve competition in the services sector, beyond minor adjustments, is lacking. The measures taken or announced to make the transition of older workers into retirement more flexible and to adjust personal income tax rates and allowances can be expected to have only a limited impact on improving incentives to work. Table 2.1:Summary table on 2016 CSR assessment Source: European Commission

3. Summary of the main findings from the MIP in-depth review

The Alert Mechanism Report 2017 called for further in-depth analysis to monitor progress in unwinding the imbalances identified in the 2016 macroeconomic imbalance procedure (MIP). The macroeconomic imbalances relate to Germany’s very large and increasing current account surplus and strong reliance on external demand, which expose growth risks and underline the need for continued rebalancing towards domestic sources. Analysis integrated into this report provides an in-depth review (IDR) of how the imbalances identified have developed. In particular IDR relevant analysis is found in the following Sections: public finances, fiscal frameworks and taxation in Section 4.1, issues relating to the banking sector and housing market in Section 4.2, labour market, education and social policies in Section 4.3, investment in Section 4.4, and sectoral policies in Section 4.5. 3.1. Imbalances and their gravity The very large current account surplus reflects not only the successful export orientation of Germany’s manufacturing sector, but also an accumulated excess of national savings to investment. In principle, a current account surplus is in line with the structural characteristics of the German economy. However, the pace at which it has been accumulated and its persistence cannot be explained by fundamental factors alone. ( ) Rather, the surplus is the result of the interplay between various domestic and external factors, including the two negative private investment shocks after the bursting of the internet and the financial market bubbles and, more recently, a significant positive terms-of-trade effect despite the depreciation of the euro. ( ) These factors have over time pushed up net savings across all sectors of the economy, while at the same time restraining private consumption and private and public investment. Overcoming investment weakness is also seen as a key factor in boosting potential GDP in Germany, thereby preparing the economy for demographic change. Private investment has remained restrained despite the low interest rate environment. Private investment constitutes around 90 % of total investment. Although private investment has largely bounced back to pre-crisis levels after 2009, investment in machinery and equipment, in particular, has not matched pre-crisis growth and non-residential construction investment has stagnated after years of decline prior to the crisis (see Graphs 1.2 and 1.3). Uncertainty over business prospects may have contributed to investment restraint in recent years. However, a more forceful pick-up could still have been possible in view of favourable financing conditions and low interest rates. This suggests it may be useful to review potential obstacles to private investment beyond uncertainty. This includes inefficiency in corporate taxation, the administrative burden, the underdeveloped venture capital market, regulatory restrictiveness in the services sector, and implementation delays in electricity and broadband infrastructure projects. Public investment has been subdued and consistently below the euro area average for a long time. This reflects a gradual scaling back of investment in maintenance and expansion of public infrastructure. It is also partly a reaction to the post-unification investment boom in eastern Germany and the consolidation needs in western Germany, notably at municipal level. The 2014 in-depth review identified an additional annual public investment requirement of ½ to 1 % of GDP (about EUR 15-30 billion) over the coming years to maintain and modernise Germany’s public infrastructure and remove specific bottlenecks. (European Commission, 2014) The design of federal fiscal relations may have contributed to protracted underinvestment, especially at municipal level, where net investment has been markedly negative over several years until 2015. Sluggish consumption growth also contributed to subdued domestic demand and the building up of the external surplus. High unemployment, a long period of wage moderation and a fall in the total number of hours worked in the first half of the 2000s resulted in low growth in disposable incomes. Wage growth has accelerated since 2008, but not to the extent the tightening labour market situation and unit labour costs in relation to the euro area average would suggest. In addition, disincentives to work for certain groups are reducing labour supply, disposable income and consumption opportunities. These include a high tax wedge, especially for low wage earners, disincentives for second earners to increase working hours and the favourable fiscal treatment of mini-jobs. 3.2. Evolution, prospects, and policy responses The current account surplus has continued to grow and is likely to remain high. While terms-of-trade effects account for a significant part of the recent increase in the external surplus, economy wide deleveraging has resulted in a further widening of the domestic saving-investment balance. The current account surplus is expected to remain very high, above the MIP threshold, and to decline only gradually over the medium term (see Section 1). The private investment-to-GDP ratio has remained unchanged. Non-financial corporations have continued accumulating equity buffers and scaling down debt financing. They have not used the additional savings or tapped the liquid bank credit market to increase domestic investment spending, which has grown more slowly than before the crisis. The continued weakness of business investment in recent years remains at odds with highly supportive conditions for capital formation, such as healthy corporate balance sheets, very low interest rates and a stronger cyclical position. While some steps have been taken to improve the regulatory framework for venture capital, limited progress has been made in improving the efficiency of corporate taxation and stimulating competition in the services sector. There is still no clear upward trend in the public investment-to-GDP ratio. Public investment as a proportion of GDP has remained largely constant and is below the euro area average (see Section 4.4). This is despite the measures taken over the last few years and strong increases in public investment at general government level in 2015 and 2016. Net investment remained negative at municipal level in 2015. Additional measures were taken in 2016 which should increase the scope for public investment, including at federal state and municipal level, such as a reform of federal fiscal relations. A planned federal transport infrastructure company and an infrastructure investment consulting service for municipalities could help break down important barriers to public investment (see Section 4.4). This could also contribute to wider benefits of EU funding instruments. While the recovery in private consumption has continued, household savings have reached record high levels. The low interest rate environment may have exacerbated households’ propensity to save instead of incentivising investment or consumption. Real wages increased more dynamically in 2016, but this reflects undershooting inflation rather than more ambitious wage agreements. Moreover, an increase in the wage share has been offset by higher income taxes and social contributions. In fact, tax revenue as a proportion of GDP has increased owing to the favourable economic and labour market situation (see Section 4.1). Measures to limit the tax burden on labour have remained modest, while disincentives to increase hours worked remain in place for second earners and mini-job holders. 3.3. Overall assessment Germany runs a persistently large current account surplus, which reflects an excess of saving over investment, but also a highly competitive manufacturing sector. The size and persistence of the surplus can only be partly explained by the industrial structure and other characteristics of the German economy. In fact, subdued investment and private consumption, resulting in an excess of saving over investment, have also contributed to the build-up of the external surplus. This can be partly explained by necessary adjustments in the aftermath of the post-unification boom, including prolonged wage moderation, labour market reforms and significant scaling back of construction activity. By contrast, private consumption is at the root of the ongoing shift towards more domestic demand-driven robust growth. At the same time, consumption and investment have remained at relatively low levels in light of the favourable cyclical, labour market and financing conditions and infrastructure investment needs. Continued relatively weak investment also undermines Germany’s future growth potential. Private consumption has strengthened somewhat and is expected to continue doing so. At the same time, private investment has remained restrained, despite the favourable financing conditions. Public investment has picked up, though budget projections indicate scope under EU and national fiscal rules for increasing public investment further. Persistently low investment could hamper Germany’s economic growth in the long term. Stronger capital accumulation would be needed to increase potential growth in the future, especially if immigration slows down and population ageing intensifies. Given the German economy’s size and strong trade and financial linkages with the rest of the euro area, further strengthening its domestic demand would also lend support to the euro area aggregate demand and inflation. Existing economic challenges for the German economy also have wider implications for the euro area. This is of particular relevance in a context of low growth and low core inflation. Even more dynamic domestic demand in Germany could help firm up the ongoing euro area recovery, overcome the risk of a ‘low growth, low inflation’ trap and ease deleveraging needs faced by highly indebted Member States. For illustrative purposes, the effects of an increase in public investment and a reduction in the personal income tax on domestic and foreign GDP are presented in Box 3.1. Overall, the policy response to address the imbalances has so far remained limited. Although relieving municipalities of certain social spending obligations and the agreed reform of federal fiscal relations will strengthen the fiscal position of the federal states and municipalities, it still remains to be seen to what extent this additional fiscal space will actually be used for additional public investment. A federal transport infrastructure company can be expected to accelerate public investment. On the other hand, the reform falls short of increasing the tax autonomy of the federal states and municipalities, which could have further increased the scope for public investment. Efforts to improve the business environment for private investment have remained limited. The same holds for efforts to reduce the high tax wedge for low-wage earners and disincentives to work for second earners with a view to supporting, labour market participation, disposable income and consumption.

(Continued on the next page) Box (continued) Table 3.1:MIP assessment matrix – Germany Source: European Commission 4. Reform priorities 4.1.Public finances, fiscal frameworks and taxation* ( ) Budget projections indicate scope under EU fiscal rules, while the leeway under national fiscal rules appears more limited. The Commission 2017 winter forecast, which covers the period 2017-2018, projects that the structural balance will stay about 1 % of GDP above the medium-term objective and that the debt ratio will remain on a firm downward path beyond the requirement of the debt rule. This is also due to the very low interest rate environment and the ‘safe haven’ status of German public debt. There is less scope for increasing public investment under the national ‘debt brake’ that has set a structural deficit limit of 0.35 % of GDP for the federal budget since 2016. However, a structural balance of around 0 % of GDP in 2017 and 2018 (as projected by the 2016 Stability Programme) suggests that some space may be available in the federal budget (Table 4.1.1).

Table 4.1.1:Budgetary projections for Germany compared to European and national deficit ceilings Source: European Commission, European Commission 2017, Federal Ministry of Finance, 2016a Tax revenue continues a favourable path. Tax revenue took a hit after the financial crisis, but has regained strength since 2010 and increased by about 1.7 percentage points of GDP in the period until 2015. The Commission’s 2017 winter forecast projects the tax ratio to stay flat over the period 2016-2018. Notably, the latest projection of tax revenue undertaken by the Ministry of Finance suggests that tax revenue is projected to rise over 2016-2020 by about 0.6 % of GDP. Assuming a largely constant expenditure-to-GDP ratio, and that the revenue-to-GDP ratio is kept constant, this suggests room of about EUR 19 billion that could be used for a targeted reduction in labour taxes. The tax wedge for low income workers is still among the highest in the EU and disincentives for second-earners persist. In 2015 the tax wedge amounted to 45.3 %, among the highest in the EU-28, reducing take-home pay and consumption opportunities. ( ) To ensure that the subsistence level remains tax-free and to offset the impact of fiscal drag, the minimum personal income tax allowance and child allowances have been increased and income tax brackets have been adjusted. These measures tend to benefit low and middle income groups because they are affected by fiscal drag relatively stronger than high income groups. However, their impact on the tax wedge will be limited. In addition, joint taxation of income for married couples (Ehegattensplitting), in addition to other non-tax related factors (see Section 4.3.1) remain disincentives to work for second earners – in many cases women (European Commission, 2016a and Böhmer et al., 2014). Several options are being discussed to reduce the tax burden on labour for low-wage earners, as has been consistently included in the country-specific recommendations to Germany. The current political debate focusses partly on possible scenarios to reduce or remove the steep increase in the marginal tax rate for middle and low income groups in personal income taxation (‘Mittelstandsbauch’). Other reform scenarios to relieve middle and low income groups from taxation that are currently under discussion include a reduction or abolition of the solidarity surcharge and reductions in social contributions for low-wage earners. Such reforms are likely to also impact on the high tax wedge for low-wage earners. Box 4.1.1 analyses the distributional and fiscal effects of certain reform scenarios to relieve middle and low-wage earners from taxation. The overall income tax burden on corporations remains high, while the tax system is complex and includes inefficiencies. When accounting for the local trade tax (Gewerbesteuer) and the solidarity surcharge, the top statutory tax rate on corporate income reached 30.2 % in 2016. ( ) This was substantially above the non-weighted EU average of 22.8 %. The effective average tax rate is 28.2 % compared with a non-weighted average of 21.1 % for the EU. The debt bias, which arises from a differential tax treatment of equity and debt, was the eighth highest in the EU in 2016. The corporate tax reforms of 2001 and 2008 have increased the relative attractiveness of retained earnings as a source of funding, but have not eliminated the debt bias. In addition, the local trade tax is prone to inefficiencies due to the inclusion of non-profit elements in the tax base. ( ) In addition to the high level of corporate taxation, the tax system is complex and tax administration costs are high (see Section 4.4.2). The planned strengthened competence of the Federal Government in the area of tax administration could help optimise the administration’s performance. If implemented effectively, additional general and IT-specific functional authority of the federal tax administration in relation to the states’ tax administrations as agreed as part of the reform of federal fiscal relations could facilitate an accelerated modernisation of the tax administration. The fight against tax fraud and evasion, both at national and international level, could benefit from such modernisation. For instance, modernisation could pave the way for addressing the currently strictly limited exchange of data between the different tax administrations and for involving the federal states in cooperation with other Member States at EU level. Several additional measures to curb tax evasion and avoidance have been proposed by the Federal Government. The measures partly respond to new EU transparency rules. Moreover, the Federal Government put in place, among other things, new requirements for electronic cash registers to curb the manipulation of sales information. On 21 December 2016, the Federal Government adopted a bill to fight tax evasion and to amend other tax provisions. This draft law contains national provisions for greater transparency, including the abolition of bank secrecy for tax purposes and the introduction of reporting requirements for financial institutions on letterbox companies. The Federal Government has adopted legislation defining the preparation and endorsement process for the macroeconomic forecasts that underpin budgetary projections. The Commission Opinion on Germany’s Draft Budgetary Plans for 2015 and 2016 (European Commission, 2016c), among others, has pointed out that no independent body in charge of producing or endorsing macroeconomic forecasts has been put in place within the meaning of Regulation (EU) No 473/2013. In response, the Federal Government has adopted a draft law that defines the preparation and endorsement process for macroeconomic forecasts. It will be complemented by implementing provisions appointing the institution responsible for the forecast endorsement. The Federal Ministry of Finance has in the 2015/2016 cycle carried out spending reviews with a view to improving the effectiveness of federal budget spending. The first cycle of spending reviews focussed on smaller policy programmes (‘support of combined traffic ( )’ and ‘support of professional mobility of young people seeking vocational training in Germany’), with a view to setting up the assessment framework and procedures. For the 2016/2017 cycle, further spending reviews are foreseen, with a focus on programmes from the policy fields ‘housing’ and ‘energy and climate’. 4.2. Financial sector 4.2.1.Banking sector The German banking sector is medium-sized and relatively well capitalised. With assets equal to about 252 % of GDP the sector is significantly smaller compared with the banking sectors e.g. in France (386 %) or the Netherlands (379 %). The German financial sector has relatively strong cooperative and public bank pillars with a relatively low concentration of banks. It has increased its resilience, including by increasing its core capital ratio (CAR) Tier 1 somewhat above the euro area average of 14.3 % (Table 4.2.1). ( ) ( ) The main contribution came from the reduction in risk-weighted assets over time, but raising capital from retained earnings is more challenging. In 2015, German banks transferred EUR 9.7 billion of their profits to capital, which is 37 % of total profits before tax (Deutsche Bundesbank, 2016b). Table 4.2.1:Financial soundness indicators, all banks in Germany Source: European Central Bank Sustaining profitability remains the biggest challenge for the business models of German banks. A return on equity of 0.8 % in June 2016 ( ) – among the lowest in the EU – and a further deteriorated cost/income ratio of 70.4 % at the end of 2015 (Deutsche Bundesbank, 2016b) raise questions on the viability of the German bank’s business models and indicate a need for cost reductions. In 2015, profits were supported by an all-time low of net additions to risk provisions, due to the favourable operating environment and improved asset quality. Should economic conditions weaken, provisioning would have to rise to normal levels again, leading to declining profitability and more challenging generic capital increases. German credit institutions still rely strongly on the traditional interest business. In 2015, German banks partly increased interest rate and liquidity risk to limit the decline in net income from the interest business to EUR 0.9 billion. Banks issue loans with longer maturities, while maturities on the liability side remain rather short (e.g. overnight deposits). This makes the sector, in particular cooperative banks and savings banks, more vulnerable to a potential increase in interest rates, especially if it were to occur suddenly. ( ) Further efficiency improvements and cost cutting efforts appear necessary to strengthen profitability. In 2015, German banks increased net fee and commission income by EUR 1.2 billion to counter headwinds on generating net interest income. Banks have also undertaken a number of measures to reduce costs. This is reflected in the number of branches which declined by about 3.5 % in 2015 (Deutsche Bundesbank, 2016b). Consolidation is ongoing within the savings and cooperative banking sectors (e.g. by closing unprofitable branches) and is expected to start also in larger banks in the light of announced consolidation measures. Nevertheless, without further cost-cutting measures, the ability to increase profitability and thus to build up more capital seems limited. This however would be necessary to hedge against the increased exposure to interest rate risks and a possible weakening of the banks’ operating environment, and to better face the challenges of digitisation. The digital transformation of financial services has strongly affected the German banking sector in the last few years. It is estimated that by 2020 almost half of all German bank customers will use a digital bank account (Drummer et al., 2016), and financial technology (FinTech) companies will jeopardise between 29 % to 35 % of all bank revenues. Overall, Germany is the second largest FinTech market in Europe, after the UK, with the total market volume of FinTech businesses in the financing and wealth management sectors accounting to EUR 2.2 billion in 2015. Almost 87 % of surveyed German financial institutions currently cooperate or plan to participate in a FinTech business in the future (Dorfleitner and Hornuf, 2016). Digital transformation is bringing new products and processes developed either by traditional banks or new players – often technology companies – which enter the financial services market and place major competitive pressure on existing financial institutions. For instance, in 2016 the FinTech market for payment solutions already reached a transaction volume of EUR 17 billion. As a result, banks are already implementing a major technological change of the entire value chain. This results for example in lower operational costs and innovative products and services. Compared to new players (i.e. FinTech firms), they can count on a vast customer base, broad product portfolio, strong brands and the funds necessary for the transformation. However, some smaller banks, operating on a more limited geographical area with fewer products, appear to be catching up more slowly with innovations in financial services. Therefore, their business models and profitability may be challenged by the new FinTech competitors.

4.2.2.Housing market* Following a prolonged contraction period, the German housing market is currently in a dynamic phase. ( ) Recent upward dynamics in real estate prices in Germany result from strong housing demand and insufficient housing supply. As a result, house prices have accelerated noticeably in real and nominal terms since 2010 (Graph 4.2.1). In 2015, house prices increased by around 4.5 % and continued to grow even more strongly in 2016. On the one hand, strong demand for houses has been supported by the growing number of households, positive income prospects, and low nominal interest rates that create favourable loan and investment conditions. On the other hand, insufficient and relatively inelastic supply was exacerbated by structural factors such as regulatory hurdles (i.e. regulations for construction land as well as environmental and energy efficiency standards) (Deutsche Bank Research, 2016). Reducing constraints to building supply would help to alleviate existing price pressures. It would also strengthen private investment. Graph 4.2.1:House price trends in Germany Source: OECD In contrast to regional price developments, aggregate house prices in Germany appear to be developing in line with their underlying fundamentals. European Commission calculations do not suggest a potential overvaluation on a national scale as house prices appear to be around a fair value. Though aggregate house prices in Germany still appear to be in line with the underlying fundamentals (e.g. measured by affordability indicators such as price-to-income and price-to-rent ratios) (Graph 4.2.2), these aggregate figures mask significant regional differences in housing market dynamics. Graph 4.2.2:Price-to-income and price-to-rent ratios Source: OECD, ECB, BIS, European Commission Upward dynamics in property prices are concentrated in agglomerations, where demand is expected to increase further in the future. ( ) In 2015, upward dynamics in real estate prices were most pronounced in large cities (6 % compared with 3 % to 4 % economy-wide) (Graph 4.2.3). In these areas, overvaluations of residential properties amounted to 10 % to 20% suggesting that prices decoupled from their underlying fundamentals (Deutsche Bundesbank, 2016c and 2016d). ( ) Although accommodation in cities tends to prove more expensive for immigrants, metropolitan areas seem to be particularly attractive owing to job opportunities, personal connections, available public infrastructure as well as lower linguistic and cultural barriers (Federal Statistical Office, 2016a). ( ) ( ) Large cities attract primarily not only young people and foreigners but also elderly people who prefer urban areas to rural ones because of infrastructure advantages. If growing population and urbanisation trends prevail in the future, it may further increase house prices. This could have social implications as socially vulnerable people may be crowded out of the cities to peripheral areas. Graph 4.2.3:Rents versus house prices Source: European Commission calculations; Association of German Pfandbrief Banks (vdp); Federal Statistical Office; Deutsche Bundesbank Purchasing prices for houses have grown faster than rents but new rents have started to catch up since 2013. In the period 2010-2016 rent indices that refer to Germany as a whole, including also rural areas, rose by 7.6 % (in Berlin by 10.2 %). The real rent index, which is adjusted for consumer price inflation, grew by 0.3% (in Berlin by 2 %). Comparing rent and price trends indicates whether the actual real estate price development is fundamentally justified. Over the same period, new rents – expressed as a percentage of rents and prices – increased economy-wide by around 20 % (in Berlin by 46.4 %). This was significantly less than purchase prices over the same time (52.4 % and 79.5 %, respectively). New rental contracts reflect the price hike as landlords are passing higher purchasing prices to tenants. As a consequence, new rents have drifted apart from the overall rent index since 2011 (Graph 4.2.3). A rental price brake introduced in Germany in 2015, applies to property markets experiencing significant price pressures and aims at curbing rent hikes on new tenancies to 10 % above existing rental benchmarks. ( ) In spite of strong growth in construction, the expansion of housing supply seems insufficient to match demand. In response to accelerating house prices, German construction investment rose on average by 1.9 % between 2010 and 2016. Prices for building land picked up with a time lag of around four years and have been growing at an accelerated pace since then. Between 2010 and 2014 the average annual growth rate of construction completions was 11 %. Yet, it slowed to 1 % in 2015. Completions amounted only to 248 000 in 2015, although projected demand – taking immigration into account – is estimated at 350 000 annually until 2020 (Graph 4.2.4) (Federal Ministry for the Environment, Nature Conservation, Building and Nuclear Safety, 2016). ( ) Moreover, only around 57 000 social dwellings were finished between 2010 and 2016 (German Bundestag, 2016). With an increase of 23 % (year-on-year) during the first 11 months of 2016, the number of building permits indicated the strongest increase in scheduled building activity for 17 years. ( ) Permits for dwellings in residential homes showed the highest increase (125.4 %, year-on-year) largely due to the construction of shelters for asylum seekers and refugees and temporary homes (Federal Statistical Office, 2017). Graph 4.2.4:Building permits and construction work completed for dwellings Sources: European Commission calculations; Federal Statistical Office Investment in new dwellings picked up after 2010 but most of the housing investment corresponds to renovating existing properties. Investment in new dwellings had touched bottom in Germany in 2008/2009 before rebounding noticeably after 2010. Despite a pick-up of investment in new owner-occupied properties and new apartments, most expenditure, with a constant share of around 70 %, is used for renovating and modernising existing dwellings. In 2015, almost 28 % (EUR 36.4 billion of total EUR 130.8 billion) of investments in existing dwelling have been used for energy related investments while the share of investments in energy-saving measures was around 32 % in 2010 (EUR 38.6 billion of total EUR 118.9 billion) (Graph 4.2.5). In contrast, during the mid-1990s refurbishment and new investment were almost balanced (Gornig et al., 2016). Graph 4.2.5:Structure of housing investment Source: European Commission; Bundesministerium für Verkehr, Bau und Stadtentwicklung (BMVBS); Deutsches Institut für Wirtschaftsforschung (DIW) The refugee inflow is estimated to have a limited positive effect on real estate prices and rents. According to Deutsche Bundesbank (2016c), the effect of the inflow of refugees on rents and house prices could amount to a ½-1 percentage point increase over the next two years. Simulations using the European Commission's QUEST model give similar values. Higher demand for housing in response to the refugee inflow raises the price of housing in the economy. Increased housing demand also leads to additional housing investment, which is, however, subject to supply constraints on land and in the construction sector. The simulation results suggest a price increase for housing of around ½ % over a two-year period and around 1½ % over ten years. In spite of recent price dynamics, available data suggest that the housing market does not constitute a risk to financial stability. Since 2010 there has been no indication of falling borrowing standards for mortgages (European Central Bank, 2016b). Though increasing, credit volume for housing purposes has remained at a moderate level (3.7 % in November 2016, year-on-year) compared with the 1980s and 1990s. The overall outstanding stock of mortgages increased nominally by 12.5 % between November 2012 and November 2016. At the same time, the overall indebtedness of private households (as a percentage of GDP and of disposable income) fell steadily from the early 2000s. The share of new mortgage loans for housing purposes with a long-term fixed interest rate for 10 years increased from around 30 % in 2010-2014 to around 45 % in early 2015 (Deutsche Bundesbank, 2016d). ( ) Draft legislation has been adopted to reinforce macroprudential policies ensuring financial stability. In response to the recommendation by the Financial Stability Committee, the Federal Government put forward a draft law to introduce counteractive measures. ( ) The law provides the necessary legal basis to allow the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht) to introduce minimum requirements for the credit-based financing of residential property purchases (e.g. caps on loan-to-value ratios, debt-to-income ratios, debt-service-to-income ratios, debt-service-coverage ratios and amortisation requirements). The use of these instruments will depend on the assessment of potential risks to financial stability arising from excessive debt and price bubbles on the real estate market. 4.3. Labour market, education and social policies 4.3.1.Labour market* The German labour market is performing well but given population ageing looming there are additional risks of labour and skills shortages. The employment rate reached 78.9 % in the third quarter of 2016 (age 20-64). Employment grew particularly in services attached to businesses, public services, education and the health sector. Unemployment decreased to 3.9 % by the fourth quarter of 2016 (Graph 4.3.1). In this context, there is a scope for tapping the considerable potential for the employment of women, older workers and migrants. Graph 4.3.1:Labour force indicators Source: European Commission Wage growth decelerated in 2016. The low level of unemployment helped to support nominal wages that increased by 2.5 % in 2016, following an increase of 2.7 % in 2015 ( ). Nominal wage growth continued to slightly outpace increases in negotiated wages. This reflects good labour market conditions and possibly still some effects of the introduction of the statutory general minimum wage. ( )

Disincentives to work and the widespread part-time work are hampering the full use of the labour market potential (European Commission, 2016a). Owing to a high share (47 %) of part-time work, Germany ranks in the bottom third of Member States in terms of its full-time equivalent (FTE) employment rate of women (57.1 % in 2015). Women with a migrant background and women with caring responsibilities are particularly affected. ( ) Better provision of quality full-time childcare, all-day schools and long-term-care is a crucial lever for increasing woman's participation in the workforce. Moreover, this lower attachment to the labour market is combined with a high gender pay gap (22.3 % compared to an EU-average of 16.7 % in 2014). ( ) The tax treatment of second earners (mostly women) is another important driver hampering female full-time employment (see Section 4.1). Moreover, disincentives to work resulting from the tax system also affect low-wage earners (see Section 4.1 and Section 4.3.3). Mini-jobs remain widespread, with about 4.8 million people having a mini-job as their only job in September 2016, which represents only a 1 % reduction in a year. According to Pusch and Seifert (2017), a significant share of mini-jobbers earns hourly wages below the general minimum. This leaves former assessments by the Commission still valid (European Commission, 2016a). In this regard, researchers do not expect a major reduction without additional measures to favour transitions to standard employment (IAB, 2016a). Labour market outcomes of people with a migrant background continue to be below average. At 57 %, the employment rate of non-EU nationals was only at the EU average in 2015, in spite of better labour market conditions and around 23 pps lower than for German citizens. Particularly affected are women with a non-EU nationality with an employment rate of 45.6 %. This was around 30 pps points below the level of female German citizens. Not only does the share of low-skilled people among non-EU nationals of working age (50.5 %) exceed the EU average (45.7 %). It is also much higher than the share of low-skilled people among German citizens (16.8 %). In addition, non-EU nationals have a lower employment rate at every skills level. The gap (25 pps) is particularly high for those with a tertiary level of education, representing a potential underuse of skilled labour (Graph 4.3.2). A major obstacle to the transition to the labour market might be the lack of German language proficiency. Only 29 % of migrants who have arrived in the last 10 years have an advanced knowledge of German (European Commission, 2016d). ( ) Labour market difficulties persist for the second generation (children of non-EU born immigrants), even if their situation has improved relatively since 2005 (Höhne, 2016). Graph 4.3.2:Employment rate difference between tertiary educated nationals and third country citizens (2015) Source: European Commission

Although the employment prospects of older workers have improved considerably, extending working lives remains a challenge, especially in the context of ageing. Extending working lives is only possible if matched with incentives for later retirement and with skills-upgrading measures based on well-targeted relevant types of learning. However, the participation of older adults (55-64 years) in life-long learning was 3.1% in 2015 below the EU average of 6.0%. While the ‘Flexi-Rente’ could contribute to a more flexible combination of pensions and additional income during the transition to retirement, it is unclear to what extent this most recent reform may offset the stronger incentives for early retirement introduced by the 2014 pension reform (see Overview table in Annex A). Despite positive labour market developments, the number of registered long-term unemployed has remained broadly stable at about 1 million (Federal Employment Agency, 2016a). Around 57 % of long-term unemployed people have been in that status for more than two years. A significant proportion of them suffer from multiple employment barriers such as low skills and a lack of language skills, health problems, care obligations or age-related problems. Jobcentres do not seem to sufficiently link active labour market policy (ALMP) measures to follow-up actions. Moreover, the per-capita integration budget for long-term unemployed recipients of unemployed benefit II (Eingliederungsleistungen) has been reduced since 2010. Protection from potential abuses in temporary work and work contracts is improving. The number of temporary agency workers has been increasing (Federal Employment Agency, 2016b). It reached around 1 million (close to 3 % of total employment) in June 2016. Temporary agency workers are often occupied in jobs requiring a relatively low skills level. The majority, in which foreigners are overrepresented, are male, young, and without vocational training. Around 20 % have previously been unemployed for at least a year or have never been employed – evidencing some foothold effects towards employment. However, around 50 % of temporary agency contracts are of very short duration and terminated in under three months. To prevent the abuse from work contracts (i.e. the unnecessary substitution of temporary workers for permanent workers) and downward pressure on wages of temporary agency workers, a law was adopted in 2016 providing equal pay after nine months of working in the sector and the introduction of a maximum transitional period of 18 months after which these workers must be hired by the company. ( ) 4.3.2.SOCIAL POLICY (POVERTY AND SOCIAL ASPECTS OF SOCIAL SECURITY SYSTEMS) The good labour market performance of recent years has not led to a decline in poverty. At the end of 2015, a rising proportion of the total population was receiving one form of minimum income support (9.7 % compared with 9.1 % in 2014, respectively). ( ) The at-risk-of-poverty rate has stabilised at a relatively high level following earlier increases. Particularly vulnerable are the unemployed, for whom the at-risk-of-poverty rate remains considerable (69.1% in 2015). This stems partly from the proportion of long-term unemployed people who are only eligible for the means-tested basic income support. In-work poverty has steadily increased in Germany in recent years and is above the EU average (in 2015, 9.7 % compared with 9.5 %), which partly relates to the high proportion of part-time employment (see European Commission, 2016a). The at-risk-of-poverty rate in old age (i.e. above 65) is also above the EU average (16.5 % in 2015 compared with 14.1 %) and the number of people at risk of old-age poverty is expected to increase in the coming years. Nevertheless, severe material deprivation has remained broadly stable, hovering just below 5 % (4.6 % in 2005 and 4.4 % in 2015). Going forward, pension adequacy is expected to deteriorate. Most recent government reports forecast a further decline in the replacement rate of the statutory pension scheme from 47.7 % in 2015 to 44.5 % by 2030 and to 41.7 % by 2045 (Federal Ministry of Labour and Social Affairs, 2016a and 2016b). Moreover, until now the take-up and coverage of second- and third-pillar schemes is too low to fully compensate for the decrease in the replacement rate of the first pillar. Coverage is particularly low among people who are at high risk of insufficient accrual of public pension benefits such as low wage earners, part-time workers or people with atypical jobs or an interrupted employment history (see Section 4.3.1). Accordingly, the long-term net replacement rate is significantly below the OECD average for both low and average wage earners (OECD, 2015a). ( ) The adequacy of pension incomes is further negatively impacted by the current low level of interest rates, which jeopardises the rate of return of private pension schemes. The gender pension gap in Germany, which compares the average retirement income (i.e. pension) between women and men, is one of the highest in the EU (in 2015, on average 45.7 % compared with 38.3 %, respectively) and older women are at a particularly high risk of poverty. The agreed measures under the proposed ‘integrated concept’ (Gesamtkonzept) for old-age provision could help to alleviate old-age poverty. These measures aim at increasing the take-up of the occupational and private pension schemes, in particular through tax credits for low-wage earners, an increase in basic public allowances and additional incentives for employers offering occupational pension schemes. Furthermore, they also aim at improving the entitlements for recipients of a reduced earning capacity pension, and at introducing allowances for people receiving a means-tested minimum retirement income. However, the Federal Government has not yet presented legislative proposals on a so-called life performance pension (Lebensleistungsrente) that recognises the long-standing labour market performance of insured workers, as it was announced in the coalition agreement (The Federal Government, 2013). The income ceilings set for pension payments currently limit contributions to the statutory pension system at a comparatively low level, given the direct link between contributions and entitlements. In addition, capital income is in general exempted from social security contributions. The provision of complete and comprehensive information on total pension entitlements in all three pension pillars is not yet a standard service. The family benefits system is not adequately tailored to families and children in need. The at-risk-of-poverty rate for children in Germany remains above pre-crisis levels at 14.6 pps, 2.2 pps above the 2006 level, which is also more than the increase recorded at EU level over the same period (1.1 pps). A key reason for child poverty in Germany is the high at-risk-of-poverty rate of single parents (33.7 % in 2015) including in-work poverty (24.3 % in 2015). ( ) Some instruments in the current family benefit system such as the tax-free child allowance (Kinderfreibetrag) favour middle-and upper-class families as they rise in line with parent's earnings. At the same time, for recipients of means-tested minimum income, the child benefit (Kindergeld) is counted as income and thus does not top up the minimum income. ( ) Other instruments set contradictory incentives. For example, the parental allowance (Elterngeld Plus) is intended to increase the labour market participation of parents, whereas the joint taxation of income for married couples (Ehegattensplitting) and free health insurance coverage for non-working spouses remain disincentives to work for second earners (see Section 4.3.1). 4.3.3.Education and skills German education outcomes are above the EU average. In 2015, education outcomes remained stable for science and mathematics and improved for reading compared to 2012 (OECD, 2016a). In these three subjects, the share of low achievers is significantly below the EU average (17 % in science, 16 % in reading and 17 % in mathematics). However, the share of low achievers in science is noticeably higher for people with an immigrant background (42.5 % for first-generation and 31.1 % for second-generation) than for people without an immigrant background (11.8 %) (Graph 4.3.3) (European Commission, 2016e). Graph 4.3.3:PISA performance in science (2015) Source: OECD Federal and regional governments have agreed to improve the quality of early childhood education and care (ECEC). The interim report 2016 by the Federal Ministry for Family Affairs, Senior Citizens, Woman and Youth and the respective ministries of the federal states provides details about the agreed aspects of quality such as child-staff ratio, staff training or management, and also identifies substantial estimated costs linked to their implementation (Federal Ministry for Family Affairs, Senior Citizens, Women and Youth, 2016). ( ) About 60 % of compulsory schools now offer all-day classes, a marked increase compared to 2002, and another means to mitigate the effects of a child’s socio-economic background. Only a small proportion of pupils attend (38 %) these all-day classes, however. The integration challenge will require additional investment in education. Germany’s general government expenditure on education remains below the EU average. This is the case both as a proportion of GDP (in 2014, 4.3 % compared with an EU average of 4.9 %) and as a share of total public expenditure (9.7 % compared with 10.2 %, respectively). However, integrating newcomers into education and training and further expanding early childhood education and care and all-day schools will require additional financial resources of additional annual investment up to EUR 3 billion annually (Autorengruppe Bildungsberichterstattung, 2016). The need for additional education resources will increase (around 300 000-390 000 places require around 30 000-40 000 extra teachers/staff). This is particularly the case in the areas of early childhood education and care, compulsory schooling and preparation for vocational education and 'dual training' that are apprenticeships combined with vocational training ( Autorengruppe Bildungsberichterstattung, 2016). A number of initiatives are underway to improve digital skills in Germany. Improved digital skills remain crucial to support digital transformation. In 2016, 67.5 % of Germans reported having at least basic digital skills. This compares with 86.1 % in Luxembourg, 77.6 % in Denmark and 73.1 % in Finland and 56.2 % in the EU as a whole (European Commission, 2016d). The use of computers by young Germans has increased between 2009 and 2012, particularly outside school, but in both areas it remains below the OECD average (OCED, 2015b). A significant number of schools do not have broadband access, in particular vocational education and training (VET) schools (Bertelsmann Foundation, 2016c). Work on exploring the future of manufacturing ('Industry 4.0', i.e. digitally-connected manufacturing) has progressed well. Following a consultation process on 'Work 4.0', a draft white paper was presented in late 2016. Education issues are being addressed in the Federal Government’s ‘Digital Agenda 2014-2017’ and in the strategy ‘Education in a digital World’ adopted by the Conference of Education Ministers of the federal states in early December (2016). The strategy covers education plans and curricula, teacher training, e-governance, education media. The ‘DigitalPakt#D’ as part of the comprehensive education strategy for the digital knowledge society announced by the Federal Ministry of Education and Research foresees mutual efforts by the Federal Government and the states to improve digital education. Whereas the Federal Government would invest EUR 5 billion over a period of five years in digital infrastructure such as broadband connections and computers in schools of all education levels, the federal states would commit to investing in digital education, including teacher training (Federal Ministry for Education and Research, 2016). Germany’s teaching force is older than that of most other comparable EU countries except Italy. The proportion of teachers aged 50 or older is around 46 % for both academic and vocational schools. The share of those over 60 has increased from 8 % in 2004 to 14 % in 2014. Estimates indicate that until 2025 there is an annual shortage of 1 600 teachers in eastern Germany compared to a surplus of 7 400 teachers in western Germany. The percentage of teachers without recognised training was at 6 % in 2014. Until 2025, teachers are most needed in chemistry, mathematics, physics, English and music (Autorengruppe Bildungsberichterstattung, 2016). Motivating enough young students to specialise in science, technology, engineering and mathematics (STEM) will be a challenge. At the same time, this provides an opportunity to upgrade and modernise teaching methods, in particular with respect to digitisation.

4.4. Investment Investment as a share of GDP has remained subdued overall in Germany in the last few years, despite strong increases in 2015-2016. The German economy weathered the crisis well, but investment activity has remained rather subdued since then and has contributed relatively little to potential growth. Germany’s capital stock increased much more slowly than that of the USA or even the rest of the EU-15. This may have slowed down potential growth, which is estimated to be 0.3 or 0.7 pps lower than that of the USA or the UK, respectively, in 2015. Although public investment increased strongly in 2015-2016, the public investment-to-GDP ratio has remained largely constant over the last few years (2.2 % of GDP in 2016). It still appears low compared to the euro area (2.8 % of GDP without Germany), despite a downward euro area trend since 2009 (Graph 4.4.1). Graph 4.4.1:Investment gap with respect to the euro area Source: European Commission While this investment gap can partly be explained by cyclical and structural developments in Germany and other euro area countries, it also reflects a sizeable infrastructure investment backlog. ( ) In particular, pronounced negative net investment over several years until 2015 suggests protracted underinvestment at the municipal level. ( ) 4.4.1.Corporate saving and investment* Non-financial corporations (NFCs) have played a key role in increasing the saving-investment surplus prior to and especially after the 2009 crisis. As far back as the early 2000’s the sector began accumulating net assets (Graph 4.4.2). On the one hand, this was helped by a declining share of labour costs, while on the other it reflected a fall in the NFC investment ratio in 2001-2002 from 13 % to 11 % of GDP, owing partly to a credit slowdown. In the years that followed, and prior to the global financial crisis, the share of labour costs continued to decline as a result of labour market reforms. This supported an improvement in the operating surplus and a mild recovery in the investment ratio. It also made it possible to raise dividend pay-outs without increasing indebtedness. Graph 4.4.2:Determinants of the savings-investment balance of non-financial corporations Source: European Commission Lower dividend pay-outs helped to rebuild company equity and have driven the increase in corporate saving and net lending. In the aftermath of the crisis, the operating surplus stagnated, while the investment ratio fell (Graph 4.4.2). NFCs focused on rebuilding equity, enabling them to reduce their reliance on external financing. Paradoxically, they became net earners, rather than net payers, of interest. More importantly, dividend pay-outs were reduced, which has turned out to be a key factor in the recent growth in NFCs’ net lending. Possibly devised as a temporary response to the crisis, this trend has continued for a number of years. It has usefully freed up some financing space for additional investment. However, the investment ratio recovered only partly and thereafter stabilised at a level just below the long-term average. The investment share of NFCs has reacted only partially to the availability of freed-up resources and remained roughly stable. There are several possible reasons for the stagnant investment ratio despite available equity and bank liquidity. According to various reports, these range from the risk-aversion of the ageing owners of family businesses or uncertainty in the face of technological change (a ‘wait and see’ attitude); the rise of less capital-intensive sectors; the increased efficiency and lower cost of equipment; and digitisation and changing consumption patterns. German manufacturing has focused on its traditional core strengths. The relative weakness in machinery and equipment investment after the crisis (Graph 1.2) and the sluggishness in manufacturing capital stock (Graph 4.4.3) conceal ongoing shifts in the structure of this sector. The sub-sectors that have been expanding capacity consistently are the automotive industry and pharmaceuticals. In comparison to 1995, their capacity (the real value of their capital stock) has grown by over 50 %. Other machine building industries have, by and large, maintained the volume of their capital stock. Other industrial sub-sectors – typically the users rather than developers of equipment – have seen their capital stock decline. Typical examples are the low-tech industries with low value-added: food, chemicals, non-metallic mineral products, basic metals and textiles. In these sectors, output has been declining, or increasing at a below-average rate. Owing to increased capital efficiency, even in these sub-sectors, output has either declined less than capacity or increased over time. Key sectors, in particular network industries, have failed to keep up. Overall, the volume of investment has more than made up for the depreciation in fixed assets, but in certain sectors capital stock has stagnated, possibly creating capacity bottlenecks (Graph 4.4.3). Investment in real estate services (housing) has been consistent and owing to its high share has helped sustain the increase in the aggregate capital stock. It has also driven a rebound in the construction sector’s capital stock. However, there are indications that housing construction may still be lagging behind actual needs (see Section 4.2.3). The infrastructure capacity of network industries (energy, water and waste management, transport, communications) has not been expanding in line with the rest of the economy. This may jeopardise the progress towards digitisation and the switch to alternative energy sources. Graph 4.4.3:Net capital stock by type of economic activity Source: European Commission calculations 4.4.2.Investment-friendliniess of the tax system Despite significant reductions in corporate capital costs, the friendliness of the tax system for private investment still ranks low by EU-wide comparison. Corporate capital costs ( ) in Germany are still high. The overall mean corporate capital costs fell by around 16 % between 2000 and 2016. This was largely driven by significant reductions in the corporate tax rate as part of the corporate tax reforms of 2001 and 2008. ( ) Although this is the highest reduction among the EU-28, corporate capital costs in Germany are still among the highest in the EU-28. Besides the high level of corporate taxation, the tax system is also complex and tax administration costs are high (see European Commission, 2016a). Several corporate taxation provisions may be hampering private investment. ( ) A recurring issue is the bias towards debt in corporate taxation. Due to a less favourable tax treatment, investments financed by equity need to earn 2.7 percentage points more in return than investments financed by debt (ZEW, 2017). This debt bias was the seventh highest in the EU in 2016. At shareholder level, the extent of the debt bias is similar. This matters in particular for SMEs, which tend to have domestic shareholders. Lowering the capital costs on equity could strengthen private investment, e.g. by strengthening the underdeveloped German venture capital market. Other features of the tax system that might distort financing and investment decisions are the inclusion of non-profit elements in the tax base of the local trade tax (Gewerbesteuer), limitations on loss carry-forwards, and tax induced distortions with respect to the choice of legal form. In addition, several specific provisions reduce the investment-friendliness of the tax system. These include the depreciation regime, the interest rate used to calculate deductible pension provisions, the taxation of capital gains, cash accounting for the purpose of value-added taxation, the high tax wedge and the negative tax incentives for second earners. There are several options for eliminating the debt bias, with varying effects on the investment-friendliness of corporate taxation. One would be to discontinue the deductibility of interest payments. Alternatively, an allowance for corporate equity (ACE) has been discussed, ( ) which provides for a deduction of a notional return on equity at corporate level, thereby improving the conditions for equity-financed investment. The effect of introducing an ACE crucially depends on the chosen notional interest rate and on a solid anti-avoidance framework. ( ) The ACE rate will determine to which extent financing neutrality is ensured, and how much effective corporate taxation is reduced, thus providing a positive impact on corporate investment and location choice. Overall, simulations based on the CORTAX model suggest that an ACE reduces the marginal cost of capital for new investments. This has correspondingly a positive impact on GDP, employment, and wages (Box 4.4.2). Lowering the cost of equity financing could also benefit in particular those companies that usually face stronger borrowing constraints, such as young businesses. Adjusting the current depreciation regime could also help to make the tax system more investment-friendly, though only to a limited extent. Although declining-balance depreciation was permitted until 2008, the German system has since opted for straight-line depreciation. ( ) Lowering corporate capital costs by re-introducing the declining-balance depreciation could improve the private investment climate. However, Spengel and Bergner (2015) suggest that declining-balance depreciation would lower corporate capital costs only slightly, hence limiting positive the impact on private investment.

(Continued on the next page) Box (continued) 4.4.3.Public investment In the last few years, the Federal Government has taken a number of measures to strengthen its own investment spending as well as that of the federal states and municipalities. In 2014, the Federal Government made available additional funds for investment in childcare facilities, public transport infrastructure and urban development. It provided financial relief to the federal states and municipalities and topped up a special fund for the expansion of childcare facilities. In 2015, it allocated for example an additional EUR 10 billion for investment in infrastructure, energy efficiency, climate and flood protection, and urban development, set up a special fund of EUR 3.5 billion to support investment in municipal infrastructure, and contributed funds to finance local public transport, expand social housing and finance energy-saving measures. Parts of the proceeds from auctioning off broadcast spectrum were made available for investment in broadband expansion. In 2016, the Federal Government provided the federal states once more with extra funds for investment in social housing and expanding preschool childcare. Overall, these measures amount to an average of about EUR 8.5 billion or 0.3 % of GDP annually over the period 2016-2018. Providing further financial relief to federal states and municipalities and reforming federal fiscal relations are expected to increase the scope for public investment. Federal states and municipalities have been further relieved of expenditure relating to asylum seekers and refugees and other social spending, which should increase their scope for public investment. Moreover, the Federal Government and the federal states agreed on a reform of federal fiscal relations that, once adopted, will take effect in 2020 (Box 4.4.3). This reform should improve conditions for public investment at all levels of government and address some of the barriers to financing and implementing transport infrastructure investment identified in last year’s Country Report (European Commission, 2016a). However, the reform fell short of more fundamental changes in terms of increasing the tax autonomy of federal states and municipalities, which could have further increased the scope for public investment. It also still remains to be seen to what extent the federal states and municipalities will use the additional fiscal space for more public investment. On the other hand, the recent extension of consulting services on infrastructure investment planning to include the municipalities should boost the planning and implementation of infrastructure investment at municipal level. This appears particularly relevant, given that the federal funds made available to support infrastructure investment in the federal states and municipalities have remained to a large extent untapped due to capacity and planning constraints. Education and research expenditure as a proportion of GDP has remained largely stable in recent years. Total consolidated public and private expenditure on education and research amounted to 9.1 % of GDP in 2013 and 2014. (Federal Statistical Office, 2016b) It therefore fell short of the national target of 10 % of GDP that the Federal Government and the federal states agreed to meet by 2015. General government expenditure on education as a proportion of GDP has remained stable at around 4.3 % of GDP since 2009 and therefore well below the EU average (4.9 % in 2014). Public expenditure on research and development (R&D) has remained stable at around 0.9 % of GDP in recent years. Total gross domestic public and private expenditure on R&D accounted for around 2.9 % of GDP in 2014 and 2015, thus Germany almost met its Europe 2020 target of 3 % R&D spending, However, Germany’s R&D intensity in 2015 was lower than in Sweden (3.3 %), Austria (3.1 %), Denmark (3.0 %) and Finland (2.9 % of GDP) and also remained behind that of South Korea (4.3 % in 2014) and Japan (3.6 % in 2014). 4.5. Sectoral policies 4.5.1.innovation, venture capital and entrepreneurial activity While investment in knowledge-based capital is crucial for long-term productivity growth, it is currently lower than in other high-income economies. In countries close to the technology frontier, such as Germany, the contribution of knowledge-based capital ( ) to productivity growth is expected to be particularly strong. Business expenditure on R&D (a sub-component of knowledge-based capital) is high in Germany by international standards. Overall, however, investment in knowledge-based capital relative to GDP is lower than in some other high-income economies such as Denmark, Sweden or the US and has grown little over time. It is particularly low in the services sector (OECD, 2016b). Strong R&D investment by the manufacturing sector contributes t