IMF urges Germany to overhaul pension system and raise taxes to fix budget

The IMF is advising the German government to follow a completely new course. To close the deficits in the budget, the monetary fund is also calling for the implementation of higher taxes in specific areas.

The International Monetary Fund (IMF) is pressuring the German government to increase wealth taxes. In its new analysis of the German economy, the IMF writes that possible options for consolidating the federal budget include “closing loopholes in the inheritance tax” and “increasing property and alcohol taxes, which are relatively low in Germany.”

Another demand is likely to resonate within political circles in Berlin. The IMF is proposing a pension reform that moves in a completely different direction from the federal government’s proposal: future pension payments would be linked to inflation, not wage increases. This would limit the growth of pensions.

Furthermore, the IMF is calling for increased deductions for early retirement to “achieve savings and at the same time stimulate growth by increasing incentives for a longer working life.”

The IMF prepares an annual analysis of the state of the German economy. This year, however, the report is likely to be read with particular interest in the country.

Germany is facing economic challenges of a magnitude not seen since the beginning of the millennium, and its economy is being tested by recession for the third consecutive year. This is an unprecedented situation in the history of the Federal Republic of Germany.

The IMF is therefore urging the federal government to support the debt program initiated in the spring with a reform program.

“Without deeper reforms both domestically and at the EU level, Germany will continue to face challenging growth prospects in the medium term,” the report states.

According to the IMF, the German economy is going through a difficult period not only at present but also in the medium term. Germany’s medium-term growth prospects continue to be overshadowed by a “slowdown in productivity growth and the rapid aging of the population.”

Among the G7 countries, no nation is expected to experience a greater contraction of its labor force than Germany over the next five years. This situation will further exacerbate the existing shortage of skilled labor.

In addition, there are geopolitical risks that pose special challenges for Germany as an exporting nation. According to the analysis, these include “intensifying geopolitical tensions, escalating trade conflicts, and fluctuations in raw material prices.” These factors could “negatively affect the German economy’s supply of essential intermediate goods, thereby weakening confidence, investment, and trade.”

In the face of ongoing growth weakness, the new federal government has announced it will reform the social state and administration. It also needs to close huge budget deficits that will total 140 billion euros by 2029.

By the end of the year, at least part of this reform agenda will be ready. So far, the government has not disclosed which specific reforms it plans.

In the spring, the federal government implemented a comprehensive debt package prepared by the CDU/CSU and SPD to modernize the German Armed Forces (Bundeswehr) and infrastructure. In its report, the IMF explicitly praises the investment program and corporate tax cuts.

“After several years of severe economic crises and negative growth, Germany’s pioneering fiscal reform at the beginning of this year paved the way for an economic recovery, supported by a gradual acceleration in domestic investment and consumption,” the IMF says.

According to Handelsblatt, this praise is hardly surprising, as the Fund has been pushing Germany to implement just such an investment program for years.

However, the IMF warns that Germany must use its debt program “prudently” so that it can genuinely increase the economy’s productivity.

Many German economists accuse the federal government of misusing the special infrastructure fund to finance election promises or cover budget deficits. The federal government denies these accusations.

Nevertheless, the IMF also offers a thinly veiled criticism in its analysis. The additional resources from the debt brake reform should be used for “public investments, aid for low- and middle-income groups, and higher defense spending.”

“Costly and distorting measures, such as reduced VAT rates for specific sectors, should be avoided,” the IMF states. This can be read as a criticism of the federal government’s attempt to lower VAT for the gastronomy sector.

The IMF notes that instead of pleasing individual sectors with additional tax advantages, the federal government should implement structural reforms.

The IMF’s specific demands are as follows:

In addition to a pension reform that will reduce the costs of the pension system, the federal government should eliminate environmentally harmful subsidies, tax breaks, and VAT exemptions. Since income tax and social security contributions are “already relatively high,” additional increases should be “kept as low as possible.”

To address the shortage of skilled labor, the state needs to facilitate full-time work for women and parents by offering more reliable child and elderly care services. Furthermore, abolishing the practice of separate income assessment for spouses and increasing the amount of child benefit could incentivize second-income earners to work more.

The unfortunate intertwining of tax and social systems makes it unattractive for low-income individuals to work more, as almost nothing is left from a higher salary. Consolidating multiple social benefits and creating more uniform payment rates could increase the incentive to enter the workforce and save the state budget money.

According to the IMF, further simplifying the integration of immigrants into the German labor market remains crucial in combating the skilled labor shortage.

The IMF also points out that excessive bureaucracy is a major competitive disadvantage for Germany. “The excessive bureaucratic burden continues to hinder productivity,” the monetary fund writes. The state needs to minimize redundancies in reporting obligations and conduct risk-based compliance checks instead of imposing overly costly reporting requirements. Additionally, there is still great potential for accelerating permit and approval procedures.

According to the IMF, one of the “most effective measures” that could boost Germany’s growth is the deepening of the EU single market. Reforms for better integration of capital markets and financial market supervision could expand financing opportunities for startups and strengthen the entire ecosystem for young, innovative companies. The digital euro could increase the efficiency and integration of payment systems across Europe.

However, Germany is struggling with the deepening of the capital market union because politicians do not want to disrupt the three-pillar system consisting of savings banks and cooperative banks.

In contrast, the federal government may soon have to reform the inheritance tax. The Federal Constitutional Court will shortly decide whether the current inheritance tax is unconstitutional.

Finance Minister Lars Klingbeil could also use the IMF as a key witness for the necessary cuts in the federal budget. The SPD politician has announced his intention to cut subsidies to close budget deficits.

However, such a rapid change of course on pensions seems unlikely. The coalition leaders want to stick to their reforms to fix pension levels until 2031. The government aims to pass the pension package through parliament within this year.