Germany's Labor-Market Reforms Could Lead to Modest Economic Improvements

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A German flag flutters in front of the Reichstag building in Berlin, Germany.

The German coalition government has agreed wide-ranging structural and tax reforms, which, combined with increased fiscal spending, should help boost the economy this year and next following years of economic underperformance, though trade-related headwinds will persist. Germany has suffered its longest period of economic stagnation since World War II in recent years, turning it from Europe's growth engine into an economic laggard. A surge in energy prices, caused first by the Russia-Ukraine War and then by the Iran war, has pushed the German economy into stagnation. The German economy is smaller today than it was at the end of 2022, having shrunk in 2023 and 2024 and only very modest growth in 2025. Due to its large, energy-intensive manufacturing base and, in part, an overreliance on relatively cheap Russian energy imports, Germany was more negatively affected than other European countries by the energy supply shocks. Moreover, Germany's core industrial sectors, such as automotive and chemicals, have come under even more intense pressure from Chinese competition, particularly in the automotive sector, which has made significant competitive and technological strides. Increased fiscal and government-financed investment has helped put a floor under economic activity, but has not yet led to a significant growth acceleration.

In 2025, the German Parliament passed a constitutional reform that exempted defense spending exceeding 1% of GDP from the constitutionally mandated structural deficit limit of 0.35% of GDP, the so-called debt brake. The reform enables Chancellor Friedrich Merz's government to increase spending on infrastructure and defense. It also established a massive 500 billion euro ($571 billion) special-purpose vehicle outside the fiscal-deficit cap to fund defense expenditure and infrastructure investment. The reform also lifted the borrowing cap for German states to 0.35% of GDP, from 0% previously.
Germany's economic growth performance has been very poor. Between 2022-25, real GDP growth averaged a mere 0.2% annually. This compares to estimated potential real growth of 1% of GDP. Following the debt brake reform in 2025, the government deficit reached 2.7% of GDP that year and is projected to increase to 3.7% of GDP in 2026.

The economic reform package introduces a broad range of measures intended to revive economic growth, although their overall impact on the investment climate is likely to be modest. On July 2, following an agreement between the two governing parties, the Christian Democratic Union (CDU) and Social Democrats (SPD), the German government unveiled a sweeping 34-point economic reform package, the "Program for Revival and Employment." The package is intended to lift the German economy out of stagnation, boost productivity growth and increase the growth effect of higher fiscal spending. The reform seeks to address a wide variety of areas, such as taxation, labor markets and infrastructure. According to the reform, lower- and middle-class households will receive 10 billion euros in tax relief starting Jan. 1, 2027, financed by a 2% increase in the tax rate for high-income households. Although deficit-neutral, this could provide a limited boost to domestic consumption, as households with lower incomes have a higher propensity to consume. The statutory retirement age will be gradually raised past 67, tracking increases in overall life expectancy and thus the rise in pension liabilities and spending. Germany will also incorporate a Swedish-style pension fund model, introducing an investment-based element into its traditional pay-as-you-go state pension system. This will help financial sector development and, over time, lead to greater capital market-based financing. The government will scale back data-protection restrictions to reduce compliance costs and make it easier for tech companies, including startups, to operate in Germany. Energy regulation will be streamlined to incentivize investment. The government will also provide financial and regulatory support to support key economic sectors, such as automotive, AI, clean tech, pharmaceuticals and semiconductors. A new federal housing construction company will be established to support the construction of affordable housing. The reform will also introduce greater labor-market flexibility and make it easier to fire high-income earners. All these measures will make it marginally more attractive to invest in Germany, given the limited extent of flexibilization and reduction of red tape.

The government is likely to pass most of the reform package by the end of the year, as the coalition holds a majority in the lower house, the Bundestag, and most measures do not require approval by the upper house, the Bundesrat. The proposed labor market, pension and administrative reforms either fall under the federal government's legislative competence or do not directly affect state finances or the states' constitutional rights. As a result, they can be adopted as so-called objection laws, under which the Bundesrat may object, but the Bundestag can override the objection with a majority vote. The proposed income tax reform, however, qualifies as a consent law and therefore requires Bundesrat approval. Nevertheless, it is also likely to pass later in 2026, as the coalition secured support from the states during negotiations by offering financial compensation and reducing the size of the planned tax cuts from 20-25 billion euros to 10 billion euros.

Chancellor Merz's CDU holds 208 seats and the SPD 120. Together, the government controls 328 seats in the 630-seat Bundestag.
Seats in the Bundesrat are not held by political parties but are allocated to the governments of Germany's 16 states. Because many German state governments are ruled by complex local coalitions that include the Greens, Free Democrats or The Left, the government coalition cannot count on a quasi-automatic majority in the upper house. This means that the government needs to negotiate with state governments to ensure the passage of "consent laws," but not "objection laws."
The Bundesrat can only influence the content of the legislation in the case of consent laws. However, in the case of the income tax reform, the federal government has already addressed the concerns of state governments, so significant modifications of the reform are unlikely. For virtually all other reforms, the upper house can only object to legislation but not block it and thereby force changes.

Once passed and implemented, the reforms will help support an economic recovery next year, but Germany will continue to face significant structural challenges and economic headwinds, including trade fragmentation and import competition. The reforms are relatively modest and will be less impactful than previous reform packages, such as the broad labor market reforms enacted under former Chancellor Gerhard Schroeder between 1998 and 2005. Bureaucratic red tape, high energy prices, high labor costs and relatively inflexible labor market regulation will continue to weigh on investment and innovation as well as productivity and economic growth. Key economic sectors, such as chemicals and autos, will remain under significant pressure from cheap, competitive imports. Nonetheless, increased government investment and defense spending will provide support to the German economy, particularly in 2027 and 2028, when the so-called fiscal impulse, measured as the change in discretionary spending, will be greatest. Economic growth is set to accelerate to as much as 1.2%-1.5% by 2028, according to varying estimates by the Bundesbank and the International Monetary Fund. But the proposed structural reforms are too limited to translate into economic growth of much more than 1% over the medium term, including because of poor demographics. Productivity spillover effects from higher fiscal spending will be somewhat limited, given that a larger share will go toward defense, which is less productivity-enhancing than, for example, infrastructure investment — though higher structural demand may lead to increased private investment. Finally, the continued threat of U.S. protectionism and intensifying Chinese competition will keep core economic sectors under financial pressure and force a continued painful restructuring on German companies. As a highly trade-integrated economy, Germany will remain more vulnerable to further economic, trade and market shocks in the coming years than its European peers.

Germany's highest trade-to-GDP ratio of 80% is the highest of any major economy. The trade-to-GDP ratio is 60% in France and Italy, less than 40% in China and less than 30% in the United States. Germany's economy relies heavily on the export of complex machinery, vehicles and chemicals to the global market. It also exports more outside the European Union than France or Italy.
Between 2022 and 2025, real GDP growth averaged 0.2% in Germany, 1.8% in Italy, 1.65% in France, 1.7% in the European Union and 2.6% in the United States. The Bundesbank and German Economy Ministry forecast real GDP growth of 0.8-0.9% in 2027, rising to 1.5% in 2028.
The United States has launched Section 301 trade investigations on Germany on pharmaceutical pricing and industrial overcapacity, paving the way for sweeping tariffs on an array of industrial imports. Unlike France, Italy and Spain, Germany is not the focus of U.S. investigations into digital-services taxes. However, Germany would be affected if the United States were to impose EU-wide tariffs, not least if the European Union decides to retaliate.