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Germany: Selected Issues

Author(s):
International Monetary Fund
Published Date:
November 2004
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II. Employment, Unemployment, and Labor Supply in Germany11

A. Introduction

48. Imminent and longer-term labor market issues vie for the attention of policymakers. High unemployment is an important problem in the German economy, and fighting it has been a central focus of the government’s Agenda 2010 reforms. At the same time, concerns about demographic pressures, a declining working-age population, and slowing potential growth are also moving center stage.

49. In this context, this paper focuses on the prospects for employment, unemployment, and labor supply. It finds that the reforms of labor market institutions under Agenda 2010—including the merger of unemployment assistance and social assistance—can have a significant steady-state effect on employment (about 600,000 persons, or 1½ percent additional employment), largely due to lower unemployment. Nonetheless, on current policies—including these reforms—labor supply and employment are expected to decline in the decades ahead as aging of the population drives old-age dependency ratios to new highs. The economic consequences of aging can be ameliorated by measures to increase labor force participation12—especially for older workers, women, and youth—and there is room for additional reforms of labor market institutions. Additional measures and reforms beyond Agenda 2010 will be needed to help increase employment ratios and promote continued per capita income growth in the decades ahead.

50. The paper is structured as follows:

  • Section B describes Germany’s labor force participation, employment, and unemployment.

  • Section C discusses institutions as potential sources of labor market problems.

  • Section D presents the reforms under Agenda 2010 agreed upon to date and evaluates their impact.

  • Section E discusses the prospects for labor supply and employment with further reforms.

  • Section F concludes.

B. Labor Force Participation, Employment, and Unemployment: an Overview

51. While the overall utilization of labor is low in Germany, labor market problems are to a large extent concentrated. Compared to some OECD countries with more dynamic recent labor market performance (for instance, the United States, the United Kingdom, the Netherlands, and Sweden):

  • Germany has lower overall labor force participation and higher unemployment, with the gap in participation larger than that in unemployment.

  • The employed work fewer hours than in the United Kingdom and the United States.

  • And Germany’s employment rate is low due to unemployment in the East, unemployment and non-participation among older workers nation-wide, as well as to low participation of women—particularly in the West—and young people.

52. Germany’s labor utilization has declined to a low level (Table II-1). The average annual hours worked per person of the working age population (15-64) declined by 26 percent between 1970 and 2003, more than in most other OECD countries. As a result, in 2003 time spent working by the working age population in Sweden, the United Kingdom, and the United States was between 24 and 37 percent higher than in Germany.

Table II-1.Germany: Utilization of Labor Resources in International Perspective, 1970 and 2003(Germany = 100, unless otherwise indicated)
GermanyFranceNetherlandsSwedenUKUS
2003
Average annual hours actually worked, per person of the working population (15-64)10096107124131137
Average annual hours actually worked, per person employed10010094108116124
Participation (labor force in relation to working population (15-64))10096107111107106
Employment of the labor force (employment in relation to the labor force)100100106104105104
1970
Average annual hours actually worked, per person of the working population (15-64)1009798097
Average annual hours actually worked, per person employed10010191102101
Participation (labor force in relation to working population (15-64))10097109101
Employment of the labor force (employment in relation to the labor force)100999996
Memorandum items: Change, in percent, 1970-2003
Average annual hours actually worked, per person of the working population (15-64)-26.3-27.0-6.33.3
Average annual hours actually worked, per person employed-23.7-24.0-8.9-6.4
Participation (labor force in relation to working population (15-64))5.94.17.612.0
Employment of the labor force (employment in relation to the labor force)-8.9-7.7-4.5-1.4
Working population (15-64) 113.721.79.751.4
Total number of hours worked-16.2-11.12.756.4
Unemployment rate (2003)9.39.43.85.65.06.0
Structural unemployment (Nairu) (2003) 27.28.33.44.04.95.3
Sources: OECD Economic Outlook (2004); OECD Labor Force Statistics; and IMF staff estimates.

53. Low participation and high unemployment both contribute to low labor utilization. In comparisons to peers, the key factors behind the differences vary. For instance, in Sweden, hours worked per employee and labor force participation are 8 percent and 11 percent higher than in Germany, respectively, with lower unemployment explaining the residual 4 percent. In the United States, hours worked per employee is 24 percent higher than in Germany, explaining two-thirds of the total 37 percent difference, with higher labor force participation and lower unemployment explaining another 6 and 4 percent, respectively.13 The gap between Germany and other countries is larger in labor force participation than in unemployment.

54. Labor force participation is low among older people, the young, and women (Table II-2). Germany’s participation rate among prime-age people (25-54) is higher than in the Netherlands, the United Kingdom, and the United States. However, it is relatively low among young people (15-24) and especially among older people (55-64). Nation-wide, female participation is low, compared with other countries. While declining, female participation rates are significantly higher in the new Länder than in the old ones (71.4 percent, compared to 63.6 percent) (Table II-3). Thus, hidden labor supply appears to exist among the young, older people, and women—the latter particularly in the West.

Table II-2.Germany: Disaggregated Labor Market Data in International Comparison, 2003
GermanyFranceNetherlandsSwedenUKUS
Total (men and women)
15-64
Unemployment rate9.49.33.65.84.96.1
Labor force participation rate71.368.276.478.976.675.8
Employment rate64.661.973.674.372.971.2
15-24
Unemployment rate10.620.2 1/6.613.811.512.4
Labor force participation rate47.430.2 1/73.252.367.661.6
Employment rate42.424.1 1/68.445.059.853.9
25-54
Unemployment rate9.18.1 1/3.14.93.85.0
Labor force participation rate86.086.4 1/85.187.884.183.0
Employment rate78.279.4 1/82.483.580.978.8
55-64
Unemployment rate9.75.8 1/2.24.83.34.1
Labor force participation rate43.141.7 1/45.972.557.562.4
Employment rate39.039.3 1/44.969.055.559.9
Men
15-64
Unemployment rate9.78.33.56.45.56.4
Labor force participation rate78.073.884.280.883.982.2
Employment rate70.467.781.275.679.376.9
15-24
Unemployment rate12.318.2 1/6.714.813.213.4
Labor force participation rate49.933.8 1/73.751.971.163.9
Employment rate43.827.6 1/68.744.261.755.3
25-54
Employment rate9.47.0 1/3.05.34.25.2
Labor force participation rate93.093.9 1/93.690.191.490.6
Employment rate84.287.4 1/90.785.387.685.9
55-64
Unemployment rate9.46.0 1/2.25.74.34.5
Labor force participation rate52.047.0 1/58.775.567.968.7
Employment rate47.144.2 1/57.471.265.065.6
Women
15-64
Unemployment rate8.910.43.85.34.15.7
Labor force participation rate64.562.568.476.969.269.7
Employment rate58.756.065.872.866.465.7
15-24
Unemployment rate8.622.8 1/6.512.79.511.4
Labor force participation rate44.926.5 1/72.752.763.959.2
Employment rate41.120.4 1/68.046.057.852.5
25-54
Unemployment rate8.89.4 1/3.34.43.34.8
Labor force participation rate78.979.0 1/76.585.576.675.6
Employment rate72.071.6 1/74.081.774.172.0
55-64
Unemployment rate10.15.5 1/2.03.92.03.7
Labor force participation rate34.336.6 1/32.969.547.356.6
Employment rate30.934.6 1/32.266.846.454.5
Memorandum items
Shares in population 15-64 (2000)
15-2416.419.717.316.416.919.4
25-5462.766.167.865.667.267.2
55-6420.914.314.918.116.013.4
Sources: OECD Employment Outlook (2004); and Burniaux, Duval, and Jaumotte (2004).
Table II-3.Germany: Participation and Unemployment Rates (For the population aged 15-64, May 2003)(In percent)
MenWomenTotal
Germany
Participation rate79.265.172.2
Unemployment rate 110.59.610.1
West
Participation rate79.463.671.6
Unemployment rate 18.77.48.1
East
Participation rate78.371.475.0
Unemployment rate 118.318.418.3
Source: Mikrozensus (Statistisches Bundesamt) 2004.

55. Unemployment in the East is particularly high and cohort specific. The non-accelerating inflation rate of unemployment (NAIRU) for Germany is estimated to have been about 7¼ percent in 2003 (approximately 2 percentage points below the headline unemployment rate of 9 percent using the ILO definition) suggesting that structural unemployment was high compared to other countries (Table II-1). However, the averages hide stark differences between the new and old Länder. While the estimated structural unemployment rate in the old Länder is 5.2, in the new Länder it is 15.4 percent (Table II-4). A significant share of this is cohort-specific, in the form of people whose skills are difficult to exploit on market terms when reservation wages are relatively high (Heckman (2002)). Unlike typical structural unemployment, cohort-specific unemployment does not stem purely from inappropriate labor market institutions, although the blanket extension of the welfare and collective wage bargaining systems from the West into the East significantly aggravated unemployment there by raising reservation wages. In the West, key problems are high long-term unemployment and a general rising trend in unemployment since the 1960s.14

Table II-4.Germany: Unemployment Rates, 2003(In percent)
Unemployment rate (Eurostat/OECD definition)
Germany9.3
West 17.3
East 117.5
Structural unemployment rate (Nairu) 2
Germany7.2
West5.2
East15.4
Source: Mikrozensus (Statistisches Bundesamt) 2004.

56. There are differences in unemployment across age and gender groups (Table II-2). In the West, unemployment is significantly higher for men than for women. In the East, the differences are smaller and unemployment is high for both genders. Disparities in unemployment rates across age groups are lower than in many other countries. In particular, unlike many other European countries, youth unemployment is low in Germany. Instead, unemployment of elderly workers (54-64) is very high, due partly to generous unemployment arrangements that “bridge” to retirement.

57. Employment rates are very low among older workers, aged 55-64 (Table II-2). The employment rate of prime-age people (25-54) is only slightly lower than in the United Kingdom and the United States—despite very high unemployment in the East. Nonetheless, the average employment rate of people aged 15-64 in Germany is nearly 7 percentage points lower than in the U.S. and almost 10 percentage point lower than in Sweden. Of these differences, two-thirds is accounted for by the low employment rate of elderly workers (55 -64) in Germany, which illustrates the concentrated nature of Germany’s labor market problems. Since the early 1970s—when employment rates for elderly workers were similar across OECD countries—these rates decreased more in Germany and neighboring countries than in the Scandinavian countries and the U.S.

58. There are various reasons why people do not participate in the labor force (Table II-5). For males, study (the young) and early retirement (among elderly) are the main reasons. Half of the nonparticipating women in the West note that they are “largely supported by others in the family,” compared to 8 percent in the East. Overall, early retirement is the reason for non-participation for 31 percent of those between 15-64. On average, the share of people outside of the labor force but looking for a job is low, indicating that the discouraged worker effect is not prominent or, at least, that reservation wages are high, although the share is significantly higher in the East, particularly among women.15

Table II-5.Germany: Reasons for not Participating in Labor Market (15-64)(In percent of total non-participating people between 15-64)
GermanyWestEast
Men
Study41.641.541.8
Retirement41.841.045.2
Other16.617.513.0
Of which:
Largely supported
by other in family5.36.12.5
Women
Study24.723.033.8
Retirement23.919.946.8
Other51.457.119.4
Of which:
Largely supported
by other in family43.449.77.7
Total
Study31.129.837.3
Retirement30.727.646.1
Other38.342.616.6
Of which:
Largely supported
by other in family29.033.75.4
Source: Statistisches Bundesamt (Mikrozensus, 2004).

C. The Role of Labor Market Institutions

59. Germany’s relatively rigid labor market institutions have contributed to its poor labor market performance. Cross-country analysis suggests that key constraints are:

  • the generosity of the benefit system;

  • the high tax wedge on labor, and;

  • institutions affecting the wage structure.16

These constraints are identified as areas where Germany’s institutions are far removed from “best practice” (Figure II-1) and where reform could yield the largest gains.

Figure II-1.Germany, and Selected Countries: Labor Market Institutions, 1960-2000

Source: Labor Market Institutions Database, Nickell and Nunziata (2001), extended using OECD data.

1/ Benefit entitlement before tax in the first year as a percentage of previous earnings before tax; average over two earnings levels and three family types.

2/ A weighted average of replacement rates in the second/third year and that in the fourth/fifth year of an unemployment spell, as a ratio of the replacement ratio in the first year.

3/ Payroll tax rate plus income tax rate plus consumption tax rate; effective rates based on national accounts.

4/ Captures strictness of employment protection laws: 0 low, 2 high. Reported by OECD (1999).

5/ Captures the degree of consensus between actors in collective bargaining: 1 low, 3 high. See Nickell and others for sources.

6/ The ratio of total reported union members (minus retired and unemployed members).

60. The concentrated nature of Germany’s labor market problems suggests that certain institutional features are especially distorting. For instance, employment rates of elderly people are low due to favorable incentives for early retirement in previous decades.17 By contrast, prime-age people participate and work at rates almost comparable to most advanced economies.

61. High replacement rates in Germany’s social security system, and wide coverage, affect incentives to work. Germany’s unemployment benefit duration and replacement ratios are high compared to Anglo-Saxon countries (Figure II-1).18 Cross-country empirical studies (Fitoussi and others (2000), Blanchard and Wolfers (2000), Nickell and others (2001), and (IMF (2003)) show that these are key determinants of the incentive to work. Steiner (2003) also finds that the remaining duration of eligibility for unemployment support has a significant effect on the probability of ending unemployment in Germany. Importantly, the German system also has wide coverage and lacks strictly enforced job search and job acceptance requirements. In a context of high replacement rates, these aspects together appear key in determining the impact on unemployment (OECD, 2004b).

62. Particularly problematic are high replacement rates for low-skilled and many elderly people. Compared to the earnings from jobs at less than the median wage, replacement rates in unemployment support are high in Germany (Tables II-6 and II-7), and marginal effective tax rates on labor are very high when considering the combined impact of benefits and taxes.19 With unemployment insurance (UI) and unemployment assistance (UA) benefits depending on previous wages, disincentives are particularly high for people considering a job with a wage lower than the one prior to being unemployed—an issue relevant for many older people with relatively high wages prior to unemployment due to the seniority system guiding wage formation in Germany. The existence of a socially defined minimum income level implies similarly high replacement rates in social assistance (SA).20 Indeed, with regional differentials in benefits smaller than differentials in wages, effective replacement rates have been found to be especially high in the East (Sinn and others, 2002).

Table II-6.Germany: Net Replacement Rates for Unemployed Persons1(Compared to different earnings levels prior to unemployment)
Single parent, 2 children2 earners couple with 2 children
In percent of average production worker wage50671001505067100150
Germany10092827898999691
France8692787096928379
Netherlands9387776686868475
Sweden10092725686848369
UK6665624679726049
US6064564085837863
Table II-7.Germany: Net Replacement Rates for Long-Term Unemployed Persons1(Compared to different earnings levels prior to unemployment)
single parent, 2 children2 earner couple, 2 children
In percent of average production worker wage6710067100
Germany71637165
France60435942
Netherlands76618571
Sweden705911085
UK81718880
US48385946
Source: OECD Benefits and Wages, 2002.

63. A steady upward trend in the tax wedge helps to explain a substantial part of the increase in structural unemployment. The tax wedge—including income tax, social security contributions, and the consumption tax—increased by over 10 percentage points since 1969 (Figure II-1). This wedge affects decisions on labor force participation and the number of hours worked.21 An increase in the tax wedge leads to a rise in gross labor costs and hence unemployment as long as there is resistance among workers to a drop in net (after-tax) wages. Based on a survey of the literature, Nickell (2003) estimates that a 10 percentage point increase in the total tax wedge would decrease employment by 2-3 percent.22, 23

64. The existence of wage floors aggravates the impact of the high tax wedge on employment for low skilled workers. Even households with modest incomes face high tax wedges in Germany (Table II-8). In a flexible labor market, taxes on labor should be reflected in lower net wages, as the elasticity of supply of labor (with respect to the net wage) is low compared to the elasticity of demand (Steiner, 2004). However, wage floors—from high reservation wages resulting from the social security system and minimum “tariff” wages from collective wage bargaining—mean that for low-skilled labor the incidence of the higher tax wedge falls on gross labor compensation and thus reduces employment. Moreover, due to the system of joint taxation of married couples, marginal tax rates faced by secondary earners are high, reducing participation of women (Nickell, 2003).

Table II-8.Germany: Statutory Tax Wedge on Labor and Its Components in International Comparison, 2003(Average rate, in percent)
GermanyFranceNetherlandsSwedenUKUS
Single
No children, earning 67 percent of APW1
Total tax wedge46.737.637.644.826.227.1
Income tax14.46.82.721.412.713.9
Payroll taxes32.330.834.823.313.413.2
Employees’ social security contributions21.113.624.97.07.27.7
Total payments less cash transfers35.520.427.628.420.021.5
Employers’ social security contributions11.217.29.916.36.25.6
Cash transfers0.00.00.00.00.00.0
No children, earning 100 percent of APW
Total tax wedge52.048.343.046.631.129.4
Income tax20.813.28.523.815.816.4
Payroll taxes31.235.134.422.815.313.0
Employees’ social security contributions21.113.625.47.08.57.7
Total payments less cash transfers41.926.834.030.824.324.1
Employers’ social security contributions10.121.59.015.86.85.4
Cash transfers0.00.00.00.00.00.0
No children, earning 167 percent of APW
Total tax wedge57.050.739.951.234.234.6
Income tax29.917.720.231.218.321.9
Payroll taxes27.133.119.720.015.912.7
Employees’ social security contributions18.912.814.95.68.67.7
Total payments less cash transfers48.830.535.136.726.929.6
Employers’ social security contributions8.120.24.714.47.35.0
Cash transfers0.00.00.00.00.00.0
2 children, earning 67 percent of APW
Total tax wedge30.129.418.034.1-10.83.4
Income tax-5.64.82.021.4-16.5-11.6
Payroll taxes35.833.124.126.516.615.0
Employees’ social security contributions21.113.611.07.07.27.7
Total payments less cash transfers15.49.95.014.7-20.2-4.0
Employers’ social security contributions14.719.513.019.59.37.4
Cash transfers0.0-8.4-8.1-13.8-10.90.0
Married
Couple, 2 children, principle earner earns 100 percent of APW, spouse does not work
Total tax wedge33.540.033.739.518.315.5
Income tax-1.57.18.223.88.71.4
Payroll taxes35.038.530.924.916.614.1
Employees’ social security contributions21.113.620.47.08.57.7
Total payments less cash transfers19.515.123.321.610.39.1
Employers’ social security contributions14.024.910.517.98.16.5
Cash transfers0.0-5.6-5.4-9.2-6.90.0
Couple, 2 children, principle earner 100 percent of APW, spouse earns 33 percent of APW
Total tax wedge39.639.035.240.119.620.5
Income tax5.87.16.522.210.76.8
Payroll taxes33.836.232.724.714.013.7
Employees’ social security contributions21.113.622.57.07.27.7
Total payments less cash transfers26.916.525.022.412.814.4
Employers’ social security contributions12.722.610.217.76.86.1
Cash transfers0.0-4.2-4.0-6.9-5.20.0
Couple, 2 children, principle earner earns 100 percent of APW, spouse earns 67 percent of APW
Total tax wedge43.940.137.341.623.923.2
Income tax11.08.36.222.913.09.7
Payroll taxes32.935.234.324.315.113.5
Employees’ social security contributions21.113.624.47.08.07.7
Total payments less cash transfers32.118.527.324.416.817.3
Employers’ social security contributions11.821.69.917.37.15.9
Cash transfers0.0-3.4-3.2-5.5-4.10.0
Couple, no children, principle earner earns 100 percent of APW, spouse earns 33 percent of APW
Total tax wedge46.743.839.645.426.227.2
Income tax14.49.46.622.212.713.9
Payroll taxes32.334.433.023.213.413.2
Employees’ social security contributions21.113.623.57.07.27.7
Total payments less cash transfers35.523.030.129.320.021.6
Employers’ social security contributions11.220.89.516.16.25.6
Cash transfers0.00.00.00.00.00.0
Source: OECD, Taxing Wages Database, 2004.

65. Cross-country evidence on the impact of institutions affecting wage formation is mixed. On the one hand, strong unionization and wage bargaining coordination, and wide coverage of wage agreements, limit competitive wage-setting. This could result in upward pressure on wages and higher structural unemployment. It could also lead to a more rigid wage structure which increases unemployment persistence (Prasad, 2004). On the other hand, greater coordination may lead workers to take into account the broader economic consequences of wage demands, facilitating economy-wide wage moderation (Calmfors and Driffel, 1988). Empirical evidence on the impact of bargaining coordination and unionization is mixed, depending on country characteristics.24

66. Unemployment inertia among the low-skilled and in the East suggests that wage rigidities have prevented the adjustment of wages to shocks. OECD countries have witnessed a reduction in demand for low-skilled labor due to technological developments and globalization. In Anglo-Saxon countries, the reduction was dampened by a rise in wage differentiation across skills. Sinn and others (2002) note that in Germany (and other European countries), with wage structures more rigid and wage floors in place, the reduction in demand led to relatively large declines in employment for low skilled people and increases in unemployment. Although cross-country evidence is not available, Franz (1999) and Prasad (2004) find indeed that Germany’s wage structure has not changed significantly over several decades and, consequently, that unemployment of low-skilled people has risen much faster than that of other workers. In the case of the East after unification, collective wage agreements and relatively high social benefits imported from the West have, by raising average wages, resulted in even more pronounced reductions in demand for labor and increases in unemployment. As institutional factors taken over from the West have increased gross labor costs, the low-productivity workers have essentially been “squeezed” out of employment.

67. Empirical evidence on the impact of tight employment protection legislation (EPL) on employment is less strong. Germany’s EPL was tightened in the early 1970s, and eased somewhat in the 1990s due to the deregulation of part time work. EPL tends to prevent some jobs from being shed and, therefore, it makes firms more cautious to fill vacancies. Moreover, since EPL increases the job security of current employees, it may encourage them to ask for higher wages (Blanchard and Wolfers, Nickell and others). The cross-country empirical evidence that EPL has a decisive impact on overall rates of unemployment is “mixed, at best” (Nickell and others). Nevertheless, there is evidence of a negative link between strict EPL and the employment rates of specific groups (youth, and prime age women), as well as a positive link with long-term unemployment (OECD, 2004a).25

D. Recent Reforms and Their Possible Impact

68. Agenda 2010 has introduced several reforms to promote greater labor market flexibility. Quantifying their impact on employment and unemployment is difficult, but a preliminary assessment suggests it could be significant, although insufficient to offset longer-term demographic challenges.

69. Benefit replacement and duration ratios are being reduced, and eligibility and job acceptance requirements tightened:

  • The duration of UI is being cut. For employees younger than 55, UI duration will be capped at 12 months, and for those aged 55 and over at 18 months, effective January 2006.26 This is expected to lead to a reduction in long-term unemployment in particular, especially for older workers who could use the long duration of UI to finance (to bridge to) early retirement.

  • Unemployment Assistance (UA, Arbeitslosenhilfe) and Social Assistance (SA, Sozialhilfe) for employable claimants will be merged into the Unemployment Benefits II program (UBII, Arbeitslosengeld II), effective January 2005.27 The level of UBII benefits will be similar to SA, implying generally a reduction in the replacement rate for the 2.2 million people now in UA. The merger will also be accompanied by tighter means testing, with some 500,000 people possibly losing eligibility.

  • Job acceptance requirements are being tightened and enforced more strictly, following up more consistently on the results of job offers. This has already resulted in an almost tripling of the number of penalties imposed for not accepting a job, or the placement in an active labor market policy measure (ALMP) in 2003.28 Moreover, since July 2003, people have to notify the Federal Labor Agency (FLA, Bundesagentur fur Arbeit) as soon as they find out they will loose their job; job searchers are obliged to accept jobs further away from where they live; and the need to provide evidence that refusing a job was justified. Specifically, recipients of UBII will have to accept any legal job regardless of pay.

70. The effective reduction in replacement rates from these reforms should reduce unemployment. However, a more significant impact would require a more substantial reduction in replacement rates (Steiner, 2004; Sinn and others, 2002). The success of the tightening of the job acceptance requirements will depend on the introduction of an appropriate incentive structure in the FLA.

71. The FLA is being restructured to improve its effectiveness. Intermediation is being intensified, including by the assignment of Personnel Service Agencies (PSAs) to the local Federal Labor Agencies.29 The employment offices will be reformed, with their task and resources being shifted towards more active intermediation. In this context, profiling is being introduced. Cost savings will stem from streamlining benefit payments and cutting spending on ineffective ALMPs.

72. Several measures have been taken to rein in early retirement. In addition to the reduction in the duration of UI for employees 55 and older from 32 to 18 months, the minimum age of early retirement on account of unemployment has been raised from 60 to 63 (to be phased in between 2006 and 2008), and many of the traditional paths into early retirement are being phased out, including the official early retirement programs for specific groups of people.

73. EPL was relaxed (effective January 2004). First, the threshold number of employees above which EPL (Kűndigungsschutz) becomes binding was raised from 5 to 10 employees, with existing employees working in firms with between 5 and 10 employees grandfathered.30 Second, measures have been taken to reduce legal costs and uncertainty stemming from EPL. The range of social criteria to be taken into consideration in dismissal decisions has been limited.31 In the case of lay offs because of poor business results (betriebsbedingten Kűndigung) employees can now opt to accept a severance payment equivalent to six months wages instead of challenging the dismissal in court.

74. Other reform measures include the extension of the coverage of the Minijob arrangements. Minijobs benefit from lower tax and social security contributions—capped at 23 percent—under a simplified system. In April 2003, the income threshold for Minijobs was increased from €325 to €400 per month, and other limitations were eased. The payroll charge subsidies are now gradually phased out over a range of incomes up to €800 per month. A significant number of Minijobs have been created. However, the attractiveness of Minijobs for the unemployed is limited because they imply a large cut in unemployment-related benefits, and the bulk of the new jobs are second jobs. Indeed, adverse incentives may actually imply a negative overall impact on the total amount of hours worked (OECD, 2004b; and Steiner and Wrohlich, 2004). Other reforms include a special subsidy for previously unemployed people who become self-employed (Ich AG); loan subsidies for firms hiring unemployed people; and a reform of the Handicrafts Code aimed at liberalizing the crafts sector.32

75. Wage moderation has continued and there has been progress toward more flexible wage formation. Continued moderation of wage growth relative to productivity increases—including through negative “wage drift” (Figure II-2)—has led to a favorable development of unit labor costs and competitiveness. Other examples of increased flexibility include:

Figure II-2.Germany: Negotiated and Actual Pay Increases, 1992-2003

(In percent)

Source: Deutsche Bundesbank.

1/ Wage drift is the difference between negotiated and actual wage increases.

  • the adjustment of the collective wage bargaining framework of some sectors to allow “shop floor” agreements that take into account local and firm-specific conditions. This has allowed innovative wage and working time agreements;

  • a gradual reduction in the number of employees covered by collective wage agreements, particularly in the Eastern Länder;33

  • the lengthening of the workweek in several agreements; and

  • further deregulation of temporary work (per January 2004).

76. So far, only limited progress has been made in reducing the tax wedge on labor. To some extent, this is caused by the legal requirement that social security spending automatically be funded by payroll taxes—while spending pressures in the aging society keep rising. The government is considering de-linking health care financing from wages, which would help to limit any further increase in the already high tax wedge on labor. However, any significant reduction in payroll tax rates will require entitlement reform and containment of public spending.

77. The quantification of the impact of these reforms on unemployment and labor supply is challenging but tentative estimates suggest that it could be significant. In addition to the usual difficulties in quantifying the effect of labor market policies, the impact of a key reform—the merger of UA and SA into Unemployment Benefits II, combined with a strengthening of the effectiveness of the FLA—depends heavily on “practicalities of implementation” that are still being worked out. It is also difficult to assess the individual impact of several measures implemented simultaneously. Various German Research institutes are in the process of modeling some of the reforms, but definitive econometric estimates are not yet available. A preliminary assessment, based on discussions with researchers in the field, suggests the total long-run impact on employment to be of the order of 600,000 persons (or some 1½ percent additional employment), of which around 400,000 would be due to reduced unemployment (1 percentage point) with the remainder due to higher labor force participation (see text table below). This tentative estimate assumes good progress in strengthening the functioning of the FLA and that 90 percent of an increase in participation translates into more employment. The bulk of the impact is expected to stem from the social security reforms (the reduction in unemployment and social benefits and their duration, the increase in the minimum age for early retirement, and the merger of UA and SA. Simulations of safety net reforms suggest that larger employment gains require significantly larger cuts in benefit levels (Steiner and Jacobebbinghaus, 2003), Boeters, Gurtzgen, and Schnabel, 2003). The impact of the other measures (relaxation of EPL, Minijobs, Ich AG), although favorable, is thought by most observers to be modest. The reason is that the cross country studies suggest that large changes in labor market institutions are required to generate significant reductions in unemployment.

Germany: The Impact of Existing Reforms on Participation, Employment, and Unemployment(In thousands of people)
Implementation DateImpact on ParticipationImpact on EmploymentImpact on Unemployment
Total168586-418
Existing reforms under Agenda 2010168576-408
Unemployment benefit reform
Capping duration UI for younger than 5520060125-125
UBII (merger UI and SA)20050150-150
Reducing early retirement
Capping duration UI for 55 and older200625150-125
Raising minimum age for early retirement200614012614
Relaxing EPL200405-5
Extension coverage mini-jobs200335-2
Strengthening effectiveness FLA2003015-15
Largely endogenous changes010-10
Reducing coverage of collective wage agreements010-10
Source: IMF staff estimates based on discussions with German research institutes.

78. Thus, although the Agenda 2010 reforms are a pathbreaking step forward, on their own they will not be sufficient to correct Germany’s labor market problems. The estimates suggest the measures might reduce the NAIRU to a nation-wide average of just over 6 percent. With unemployment much higher in the East than in the West and only limited room to reduce the NAIRU in the West much below the current estimate of 5.2 percent, most of the reduction in unemployment would be expected to take place in the East. However, the high unemployment in the Eastern Länder is to a significant extent cohort-specific. While more pronounced differences in unemployment benefits across regions and measures to stimulate mobility would help, given current social preferences and the minimum income levels they render, the likelihood for unemployment reduction through changes in labor market institutions is limited. This assessment also confirms that these reforms should not be expected significantly to offset the demographic pressures and boost potential growth—the key longer-term challenges in Germany. To make inroads into the longer term challenges, more fundamental entitlement and other reforms are necessary.

E. Labor Supply and Employment Prospects with Further Reforms

79. On current policies, the working-age population and employment are expected to shrink in the decades ahead. Demographic projections suggest that the working age population (15-64, given the current statutory retirement age of 65) has already started to decline and will continue to do so in the long run (Figure II-3). The evolution in the labor force is more difficult to project, as this depends on the demographic factors and on participation rates. Participation rates could be raised with additional well-targeted policies.

Figure II-3.Germany: Dynamics of Working Age Population, 1950-2050

Source: German Authorities; Eurostat; OECD; and IMF staff calculations.

80. Therefore, to help offset the demographic pressures, a new round of labor reforms is needed to boost participation and employment. The identification of high-yield measures requires a look at the main sources of hidden labor supply. As indicated in section B, the difference between Germany and comparator countries is higher in participation rates than in unemployment rates. Moreover, while unemployment reduction is currently a top priority, from a long-run perspective the scope for boosting employment by raising participation rates is larger than from reducing unemployment. Indeed, the OECD (2003) suggests that current slack of usable labor resources is around 12 percent of employment in Germany, with over 90 percent of this amount in the form of “excess inactivity” rather than “excess unemployment”. There is thus significant scope for boosting labor force utilization, especially with measures geared at elderly workers, women—particularly in the West—and the young.34

81. Possible measures to increase the participation of elderly workers include:

  • Discontinuing the arrangements for early retirement, especially those bridging toward retirement in unemployment. Most of the early retirement arrangements are already being phased out, which has contributed to some pick up in the effective retirement age. However, consideration should also be given to phasing out the old-age subsidized part-time scheme (Altersteilzeit) and abolishing the exemption of older unemployed workers from job search requirements.

  • Achieving more complete actuarial neutrality of old-age pensions. The current discounts and bonuses—3.6 percent per year—for early and late retirement do not appear to remove fully the financial incentives for early retirement.

  • Increasing the statutory retirement age, initially to 67 as proposed. Increases in the retirement age appear unavoidable as life expectancy has risen considerably and the population continues to age. Several OECD countries already have raised the retirement age beyond 65. The “yield” of moving to higher statutory retirement ages could be quite large as it has a powerful impact on the old-age dependency ratio. In turn, as shown in Chapter 4, this is also seen as one of the more powerful policies to reduce pressures on nonwage costs in the German economy, and to sustain output growth in the long-run.

82. Reducing the disincentives to work for secondary earners (mostly women) could also generate significant additional labor supply. Two aspects are relevant:

  • The impact of improving the availability of affordable (public or private) child care is estimated to be relatively high in Germany (Burniaux, Duval, and Jaumotte, 2004), as also suggested by the situation in the East, where better availability of public child care supported higher female participation.

  • Under the current system of joint taxation for married couples, the marginal tax rates for second income earners is high. While moving to consolidated taxation would pose significant legal challenges, steps could be taken to reduce the tax rate on the secondary earner.35

83. Youth participation could also be raised. Reforms of the education system aimed at reducing duration of tertiary education could raise labor force participation of young people. These reforms could over time increase the overall participation rate by as much as 4 percentage points.36

84. Additional reforms of labor market institutions could further boost employment.

  • Further reforms to the benefit system. Currently only one in three unemployed finding a new job via the FLA. Strengthening the effectiveness of job search and implementation of the rules could thus yield significant further benefits.

  • Reductions in the tax wedge on labor. Given the pressure on public finances in the coming decades, a strategy to reduce taxes needs to be facilitated by the containment of public spending. Public finances permitting, reforms of the tax system should aim at reducing the tax wedge on low-wage labor. To some extent, the Minijobs arrangements achieve this. However, as discussed above, these do not provide appropriate incentives for benefit recipients. Exploring further the options of delinking the financing of health and social insurance from wages could help.

  • Other labor market measures. More pronounced regional differentiation of social benefits and measures to stimulate the mobility and retraining of Eastern workers would mitigate the unemployment problem in the East. In addition, measures supporting further increases in the number of hours worked could be considered, including by reducing disincentives stemming from the tax and benefit systems.

F. Conclusions

85. While labor utilization in Germany is low, labor market problems are concentrated. The total number of hours worked in Germany has declined to a low level. Compared to other countries, Germany has both lower labor force participation and higher unemployment, with the gap in participation larger than that in unemployment. With prime-age (25-54) participation and employment rates comparable to international levels, Germany’s labor market problems are concentrated in unemployment in the East, unemployment and non-participation among older workers nation-wide, and non-participation among women—particularly in the West—and young people.

86. Germany’s labor market institutions have affected its labor market performance, in particular the parameters determining the generosity of the benefit system, the high tax wedge—especially at low levels of wage income—and, to some extent, wage rigidities.

87. Various reforms under Agenda 2010 aim at reducing unemployment and increasing employment. The reforms move towards (i) reducing the benefit duration and replacement ratios of the social benefit system, and tightening requirements; (ii) improving the effectiveness of the Federal Labor Agency, and tightening the enforcement of rules; (ii) reining in early retirement; (iii) relaxing employer protection legislation; (iv) extending the coverage of Minijobs; and (v) introducing measures to stimulate self employment. A tentative estimate suggests that these measures could—over time—increase employment by about 1½ percent, of which two-thirds would stem from a reduction in unemployment.

88. On current policies, demographic pressures would affect employment as a source of potential growth in the decades ahead. The working-age population is already declining, and based on current participation patterns, the labor force would also start to shrink soon. Projections for old age dependency ratios point to the need for policy adjustments in the face of these demographic challenges.

89. There is scope for additional well-targeted measures to boost participation and reduce unemployment, even though some may be politically difficult. Participation rate of older workers could be increased by discontinuing the remaining arrangements for early retirement, ensuring actuarial fairness of old-age pensions, and raising the statutory retirement age. The incentives to work for secondary earners (women) could be increased, including by adjustments to the tax system and improving the availability of affordable child care, while the average age at which people enter the labor market can be reduced. The impact of these reforms could be substantial, allowing higher employment rates to become a significant source of per capita growth over the coming decades. Further reforms to the social security system and reductions in the tax wedge on labor could also contribute to higher participation and lower unemployment rates.

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Prepared by Louis Kuijs.

Defined as the number of employed plus unemployed as a share of the working-age population (15-64).

The decline in the number of hours worked per worker may be a less serious problem than inactivity and unemployment. Blanchard (2004) has argued that, with leisure likely to be a normal good, this reduction could reflect partly a voluntary process. At any rate, in 2003, for the first time since long, the average number of hours worked per worker increased somewhat again in Germany.

The share of people unemployed longer than 12 months in total unemployment was around 36 percent in the first months of 2004. Indeed, correcting for employment in public work programs, long-term unemployment would even be around 60 percent in the East and 50 percent in the West.

Survey data from the Mikrozensus (2004) of the Federal Statistics Office indicate the share is on average less than 4 percent, although it is 7.2 percent for women in the East.

As an indication of the relative importance, in the study of Nickell and others, 39 percent of the difference in unemployment was explained by the differences in benefit systems. The tax system, unionization variables, and employment protection legislation (EPL) explained 26, 19, and 10 percent.

Differences in employment rates between prime age males and other groups have also been interpreted as an insider-outsider issue. For instance, Heckman(2002) suggests that EPL creates “a protected enclave of insiders who experience less unemployment and wage fluctuations than the excluded outsiders.”

The benefit duration ratios shown in Figure are defined as in the empirical literature. They need to be combined with the replacement ratios to obtain the replacement rate in longer-term unemployment.

For people in UI previously earning 67 percent of the average production worker’s wage (APW) and returning to a job with the same wage level, the marginal effective tax rate (METR)—the rate at which taxes go up and benefits down as an unemployed person takes up a job—is 100 percent or higher (Carone and others (2004).

In this case, when taking up a job at 67 percent of APW or less, the METR is 77 percent or higher for all types of family composition except 2 earners couples (Carone and others (2004).

The financial trade-off between working or drawing a benefit is determined by the relation between after-tax unemployment benefits to after-tax wages (discussed above), of which tax rates are only one determinant.

Including the impact on hours worked per worker, the impact on total hours worked is likely to be higher.

Blanchard (2004) concludes tentatively that the reduction in hours worked per employee in Europe over the previous 3 decades is perhaps for one-third due to increases in tax wedges, with the rest due either to other labor market institutions, or voluntary.

Nickell and others find a favorable impact of bargaining coordination on unemployment, and no effect for unionization (although they do find an impact of unionization on wages). IMF (2003) finds two offsetting effects of bargaining coordination—with the overall impact depending on a country’s characteristics—and that stronger unionization is associated with higher unemployment.

There is also evidence that EPL-related potential costs of closure or downsizing weigh particularly on young (and small firms) (OECD (2004b)).

Currently, the unemployed aged 55 and older can receive UI benefits for 32 months, and those aged 45-54 between 18 and 26 months. Younger peoples’ eligibility is already limited to 12 months.

Non-employable claimants will continue to receive SA.

Penalties amount to 30 percent of benefits for up to three months. Young unemployed job seekers’ benefit can be fully withdrawn for this period.

The PSA can hire out people to private sector companies. They should in principle pay collective bargaining agreement wages which can be subsidized by the FLA for a limited period of time.

In addition, the time limit for temporary contracts without specific justification has risen from 2 to 4 years for newly founded firms.

They are limited to job tenure, age, and maintenance obligations for dependents.

People without a “master” certificate—which enables someone to train apprentices and run a shop—can now open a craft trade business in sectors where safety concerns are not considered to be important, which account for 10 percent of total employment in all trades.

In 2000, 63 percent of West German employees were covered by a collective wage bargaining agreement, and 45 percent of East German employees. Interestingly, though, around half of the employees not officially covered by agreements were affected by the agreements because their employers voluntarily orient their wage policies on the agreement (Kohaut and Schnabel).

International comparisons indicate that Scandinavian countries are able to combine less flexible labor market institutions with high employment rates by avoiding low unemployment rates of the young, older people and women.

See Steiner and Wrohlich (2004).

The middle of the range estimated by Burniaux, Duval, and Jaumotte (2004).

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