Germany, like many other advanced economies, is facing significant spending pressures related to climate change, defense, infrastructure and demographic change, including healthcare and pensions. Estimates by the IMF and the European Commission put projected spending needs somewhere around 2-2.5% of GDP annually. Between now and 2030, spending related to pension and health is projected to increase by 0.6% and 0.3% GDP. Defence spending needs to increase by 0.3% of GDP, while spending on climate and infrastructure ought to increase by 0.2% of GDP and 1% of GDP. In view of these spending needs, Germany should reform the so-called debt brake, which overly constrains its ability to run larger deficits to finance urgent and necessary public expenditure.
Constitutionally Mandated Debt Brake is Overly Constraining
In 2009, Germany enshrined the so-called debt break in its constitution. The debt brake limits the structural deficit to 0.35% of GDP at the federal level and to zero at the state level. On its face, the debt brake has been very successful. Measured as a share of GDP, German government debt fell by 17 percentage points between 2010 and 2023, whereas it increased by an average of 28 percentage points in the other G7 countries. Last year, all G7 countries had government debt exceeding 100% of GDP, except for Germany where debt stood at a mere 64% of GDP.
All other things equal, lower debt means sounder public finances. A low debt ratio allows governments to quickly mobilize resources in response to unforeseen shocks or in support of important policy objectives without having to raise taxes or cut expenditure. But low public debt is not an end in itself, and reducing public debt that is already at manageable levels has significant opportunity costs in terms of foregone spending and investment. In Germany’s case, the debt brake is overly constraining. Not only has its rigidity forced an unnecessarily large fiscal adjustment on the economy this year in a context where debt levels are already low and would have continued to decline over the medium term regardless. But restrictive fiscal policy, such as a failure to invest in productivity-enhancing infrastructure and national security, also has negative consequences in terms of long-term growth and national security.
A back-of-the-envelope calculation suggests that Germany can afford to run a fiscal deficit more than a full percentage point of GDP higher than what is mandated by the debt brake without experiencing an increase in the debt-to-GDP ratio. The IMF estimates that a deficit of 1.6% of GDP would suffice to stabilize the debt ratio at 60% of GDP provided nominal GDP growth averages 2.7%. If, on the other hand, Germany were to strictly adhere to the debt brake indefinitely, the debt ratio would fall to less than 40% of GDP by 2050 and less than 20% of GDP by the end of the present century. Hardly a sensible policy.
A Sensible Reform Would Afford the Government Greater Flexibility Without Jeopardizing Sound Public Finances
Current debt levels are more than manageable and adhering to the debt break prioritizes the reduction of debt over urgent spending needs. A sensible reform of the debt brake would allow the government to run larger deficits without increasing the debt ratio. Even the German Council of Economic Experts and the Bundesbank – hardly bastions of unorthodox economic thinking – support a reform of the debt brake. The Council has proposed a reform that would allow for a higher fiscal deficit of 1% when debt is less than 60% of GDP and a deficit of 0.5% of GDP deficit when debt is 60-90% of GDP. The Bundesbank has proposed a golden rule, which would allow the deficit to exceed 0.35% of GDP provided public investment exceeds a pre-specified level.
However, if the IMF and EU Commission estimates are in the ballpark, increasing the deficit limit from 0.35% of GDP to 1.6% of GDP would not be enough to cover all spending needs. But it would go some way toward addressing the most urgent expenditure needs, including defense and infrastructure. Covering all expenditure needs without raising the debt ratio will require economically and politically difficult choices to be made, such as reducing non-priority expenditure, raising taxes or improving the quality of public spending. But reforming the debt brake would make these choices politically and economically less daunting. Most importantly, however, the government could start addressing high-priority needs right away.
A country as pivotal to Europe’s economy and security as Germany needs to pursue a more well- calibrated fiscal policy. It should not adhere rigidly and unnecessarily to an arbitrary and economically-difficult-to-justify fiscal rule. Instead, a more strategic and adaptable fiscal policy should be put in place to address urgent strategic priorities and challenges, such as the defense of the realm, climate change and a declining infrastructure. Compared to its advanced economy peers, whose debt levels are far higher, Germany has some leeway to increase expenditure without having to raise taxes or reduce non-priority expenditure. Germany should therefore reform the debt brake to take advantage of this flexibility, while continuing to safeguard sound public finances.