Germany’s Election: Reform Momentum Strengthens, but Debt Brake Reform Challenging

A new Christian Democratic Union (CDU)/Christian Social Union (CSU)-led government needs to agree quickly on how to tackle the economy’s structural weaknesses while navigating increasingly protectionist and adversarial US trade and defence policies.

Based on the results, the Social Democratic Party (SPD) is likely to be the coalition partner, which should accelerate the formation of a government with fewer compromises needed compared with the alternative of a three-party coalition including the Greens.

Still, reform of Germany’s constitutionally enshrined debt brake will remain challenging as the three leading centrist parties hold just under the required two-thirds parliamentary supermajority needed to amend the Constitution. Any changes would therefore require the support from the far-right Alternative for Germany (AfD) or far-left Linke party, which are both reluctant to increase defence expenditure.

Germany needs to increase its room for budgetary manoeuvre not only due to the investment required to address structural weaknesses in the economy but also because of the pressure to increase defence spending, which has intensified with the US administration’s reluctance to continue financing Europe’s security.

EU member states in NATO are considering increasing their commitments on defence spending to 3% from 2% of GDP. This would leave many regional sovereigns with a large budget shortfall, weakening their credit profiles.

Once Germany’s special defence expenditure fund of EUR 100bn is depleted by the end of 2026, its budgetary gap would be the largest among EU member states at around 13.8% of central government revenues. This compares with Italy’s and France’s budgetary gaps of around 5% of revenue.

The 3% defence-spending target has not been reached since the end of the Cold War (Figure 1) and would require more than one-quarter of Germany’s current budget to be allocated to defence. Sufficiently reducing expenditure elsewhere or raising taxes appears highly unlikely in the near term. The incoming government may therefore have to rely on renewed special funds, approval for which would require a two-thirds parliamentary supermajority.

Figure 1: Germany military spending could shift back to Cold-War levels

Leaving aside increasing defence spending, the new administration faces a challenging list of reform priorities: establishing a clear industrial strategy, modernising Germany’s energy infrastructure, and implementing long overdue reforms in taxation, the pension system and the labour market. Together, these measures can enhance Germany’s economic competitiveness, raise growth and address growing defence and welfare spending pressures.

Increased Focus on Lowering Energy Costs from the New Government

Germany’s weak growth outlook reflects its declining international competitiveness, with high energy costs a particular problem. After post-pandemic price surges, EU natural gas prices in 2024 remained approximately five times as high as in the US. This compares with prices being approximately 1.8x US prices as of 2019.

One way to address Germany’s high energy costs is through greater investments in power infrastructure to better integrate growing volumes of intermittent solar and wind-powered electricity. However, relying primarily on private-sector commitments will keep German electricity prices among the highest in the EU (Figure 2) as firms pass on costs to end-users.

The significant investment needs for the energy transition are likely to keep electricity prices elevated compared with that in other EU countries. Still, the new government could consider reducing taxes on electricity and shifting a part of the cost for upgrading the grid to the public sector. Such measures could be possible within the existing debt-brake framework, if structured as a financial transaction.

Figure 2: Household and non-household electricity prices, EUR/kWh

Competitive Tax Regime and Labour Market Reforms to Encourage Private Investment

A more competitive personal and corporate tax regime could help raise private-sector investment and narrow Germany’s large investment gap, which Scope Ratings estimates at more than EUR 400bn more than of economies of other AAA-Scope rated sovereigns.

In addition, greater investments in education and labour market reforms could enable higher workforce participation among women and migrants. Given Germany’s shortages of skilled labour and significant demographic challenge, it will also be important that measures to tighten immigration do not discourage skilled migrants.

Reducing bureaucracy and simplifying regulation to support private sector investment have been recognised as priorities by most political parties, although any implementation of reforms will likely be gradual.

These structural reforms are critical to raising medium-term growth. Combined with a potential reform of the debt-brake rule to allow for more growth-enhancing public-sector investment, this would create additional fiscal space to help address rising expenditure needs while ensuring long-term economic resilience.

For a look at all of today’s economic events, check out our economic calendar.

Eiko Sievert is a Senior Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.