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  Assessment and Recommendations
  German economic performance continues to be marked by strong exports, reflecting many years of trend improvement in external competitiveness, but persistently weak domestic demand. To some extent these two trends are linked. Wage moderation, while strengthening competitiveness, has meant weak household income growth, holding back consumption; and lower inflation than in other euro area countries has raised the real interest rate in Germany, while the absence of exchange rate movements due to the single currency is likely to have supported exports. Signs of a pick up of domestic demand have emerged, and soft data on business confidence and incoming orders signal that the recovery may become broader in the near future. However, hard data from quarterly GDP statistics indicate that this process was not yet firmly established until the end of 2005. Overall, the OECD projects that real GDP will grow somewhat above potential in 2006, at around 1¾ per cent, after growth of 1.1% in 2005 (working day adjusted). Continued structural reform can contribute to stronger domestic activity and would improve the capacity of the economy to turn favourable external impulses into higher growth and employment.
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  Macroeconomic Developments and Policy Challenges
  After years of subdued growth and weak demand, Germany may now be in a position to enjoy a robust recovery. Further progress in economic reforms could turn this cyclical upswing into a sustained expansion, with stronger supply conditions and higher permanent incomes feeding back into more buoyant current demand. The challenge confronting Germany in this context is to improve its performance in a variety of areas – generating higher employment and productivity growth, securing the sustainability of public sector finances – while at the same time preserving what could well be a genuine recovery extending beyond the export sector. For this end, a comprehensive strategy is required. Public sector expenditure control should be linked to public sector reform. Labour market reform needs to be deepened and broadened in order to reduce hurdles to labour supply and demand. Increasing the efficiency of the education system is important to reinforce Germany’s growth potential and secure living standards in the future. Furthermore, strengthening product market competition helps to raise productivity growth and implies a redistribution of real incomes in favour of consumers.
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  Regaining Fiscal Credibility and Improving Public Sector Efficiency
  Despite substantial structural reductions in government spending relative to GDP in recent years, the government debt ratio has reached high levels and expected ageing-related spending increases remain significant. While steps have been taken to lower the government deficit from 2007 onwards, including an increase in the standard VAT rate, further measures to ensure that government finances are on a sustainable basis should include further consolidation through better prioritisation of government spending. A stronger commitment to consolidation at all levels of government is necessary, inter alia by ending the bailing-out of states in financial difficulties. Reform of fiscal federal relations should include disentangling legislative responsibilities and reducing co-funding across levels of government, as well as widening the scope for sub-national governments to raise their own tax revenue.
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  The Performance of the Education System Needs to Improve
  While average educational attainment in the population of working age is relatively high, with most individuals possessing at least an upper secondary degree, the tertiary graduation rate is one of the lowest in the OECD and secondary schooling outcomes are in need of improvement. Improving access to early childhood education, as well as a more consistent evaluation of school performance against nation-wide or state-wide performance standards, coupled with more school autonomy, notably in staffing decisions, can contribute to raising secondary education outcomes. Universities need to be given better incentives to offer attractive degree programmes with relatively short study duration, by making funding of universities more outcome-oriented and by further strengthening their autonomy with respect to budgetary, administrative and personnel decisions as well as student admissions. Student fees, coupled with a loan scheme and an income-contingent repayment scheme, should be introduced in all states.
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  Labour Market Reform Should Go on
  Major steps in labour market reform have been implemented over the last three years. These need to be followed up in several respects in order to raise the economy’s capacity to generate employment. The present tax and transfer system still implies significant disincentives for labour supply of older people and spouses, which should be eliminated. Unemployment related benefits and active labour market policies can be better geared toward activating the unemployed, while institutional reform of the Public Employment Service should continue. On the labour demand side, there remains scope to raise the efficiency of Germany’s employment protection system. Also, provisions should be made to allow for a higher degree of wage flexibility across qualifications and regions to fight unemployment.
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  Fostering Product Market Competition Would Have Large Benefits
  Much scope remains to make regulation of product markets more conducive to competition – notwithstanding progress in recent years –, with substantial benefits for consumer welfare, productivity and employment. While the general competition legislation and enforcement framework is mostly effective, measures need to be taken to reduce administrative burdens on entrepreneurship and reduce the involvement of the government in business sector activities, notably through accelerated privatisation. Policies favouring small enterprises need to be revised, with a view to fully exposing them to competition and avoiding disincentives for small firms to grow.
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