Germany needs an economic miracle. Merz's odds don’t look good.

The victory of conservative candidate Friedrich Merz in Sunday’s German election has raised hopes that this 69-year-old former corporate lawyer will wave a magic wand and end years of economic stagnation. Germany’s unfavorable demographics mean this is much too optimistic.

Notwithstanding the energetic Merz’s desire to speedily form a government and the likelihood he’ll have to drop his resistance to more borrowing to rebuild Germany’s military, an aging population precludes a repeat of the boom this country enjoyed after World War II or following Gerhard Schroeder’s labor market reforms of the early 2000s.

Demographic change is just one in a long list of structural impediments to growth, which also includes decrepit infrastructure, high energy costs, rising protectionism, weak productivity and the emergence of China as an industrial rival. Still, the retirement of the large baby boomer generation merits attention because skilled labor shortages and reduced working hours tend to reduce potential growth absent continued high immigration, which isn’t guaranteed. The rise of the far-right Alternative for Germany, who received more than one-fifth of votes, making it the largest opposition party in the federal parliament, may deter skilled foreigners from moving to the country.

Moreover, these changes will exacerbate strains on the federal budget and social security system, while further inflaming political and intergenerational conflicts about how limited resources should be divided. (Those over the age of 60 comprised 42% of those eligible to participate in Sunday’s election, compared with 26% in 1990. More than half of those oldies voted for Merz’s CDU/CSU alliance or likely coalition partner the Social Democrats.)

This could leave Merz with less wiggle room to slash taxes and thereby restore Germany’s attractiveness as a business location; his goal to raise annual economic growth to around 2% could therefore prove illusory.

Following an election campaign dominated by debates about asylum seekers, I worry German voters are unprepared for some of the hard financial choices ahead, which include raising the retirement age and curtailing wasteful health spending.

The chancellor-in-waiting has correctly identified much of what ails Germany — including excessive bureaucracy and a lack of business investment. To restore competitiveness, he’s proposed an "Agenda 2030” comprising corporate and personal income tax cuts, financial incentives for elderly people to keep working and an overhaul of long-term unemployment benefits known as Burgergeld. All his decisions will be guided by whether or not they strengthen the competitiveness of German industry, Merz has said.

But he’s given few details about how he plans to fund these tax cuts and he’ll likely have to compromise on many of his aims because the Social Democrats don’t agree.

Due partly to an anticipated contraction in labor volumes, the country’s economic growth potential is estimated at just 0.3%-0.4% per year for the remainder of this decade, compared with an average of 1.4% between 2000 and 2019, according to the German Council of Economic Experts.

During the coming four-year parliament, around 5.2 million Germans will reach retirement age, whereas only 3.1 million will turn 20 and thus stand ready to join the workforce, according to calculations by the German Economic Institute.

Elderly people require more costly health care and an aging population will further strain Germany’s pay-as-you go pension system — whereby current workers pay for current retirees. This could necessitate even bigger government top-up payments from the federal budget and pensions already account for more than one fifth of government spending.

Germany’s social protections are laudable, but high contributions can create disincentives to work and act as a brake on consumption (because workers have less take-home pay), while impairing competitiveness and job creation by driving up the cost of employment.

German incomes taxes aren’t that high by international standards, especially once you allow for generous benefits for families and tax breaks for married couples.

However, including social insurance contributions paid by employees and employers — which encompass pension, unemployment, health and long-term care insurance — the so-called tax wedge for childless singles is higher than any country in the OECD, except Belgium. (A tax wedge refers to the difference between the total cost of employing someone and their take-home pay.)

Following a big jump in health-insurance deductions this year, the overall percentage of gross income going toward social security has risen to 42%, the highest since 2003 when the Schroder government passed the Hartz reforms to boost employment and curtail spending on jobless benefits.

Merz wants to restore an upper limit of 40% but has been vague about how. Without intervention, the contribution rate could rise to nearly 46% by 2029 and 49% by 2035, warns research organization IGES Group, leaving workers with less disposable income and inflating labor costs for employers.

Yet pension reforms hardly featured in the election campaign. Both Merz’s CDU and the SPD have ruled out raising the retirement age, which is currently set to increase to 67 by 2031. Furthermore, the Social Democrats want to continue to guarantee retiree benefits at 48% of average wages; Merz says he’s in favor of stable pensions but has been less specific about how this will be achieved.

My impression is none of the parties wanted to say anything to upset pensioners. However, Germany needs to bite the bullet and link the retirement age to increasing life expectancy, while enabling more tax-advantaged saving in equities. Merz’s plan to provide all six year-olds with investment accounts and €10 ($10.48) a month to buy stocks is certainly worth pursuing, but it won’t alleviate near-term pressures on the retirement system.

Rather than expand the assessment base for health care contributions so they apply to higher incomes or other types of earnings, the system should prioritize greater spending efficiency. Sick day-prone Germans consult a doctor almost 10 times a year on average, compared with just twice in Sweden, while per capita health care spending is the third highest of OECD countries after the U.S. and Switzerland. To create more public awareness of treatment costs, Germany could apply a charge for surgery visits or apply deductibles, the Bundesbank has proposed.

To curtail labor shortages and fund its generous welfare system, Germany must also continue to attract skilled migrants and better integrate refugees into the workforce. (Without immigration, Germany’s population would have shrunk already as the number of deaths has exceeded the number of births for around half a century — fortunately many of the new arrivals are young.)

I wish Merz luck in getting Germany back on its feet. Alas, an aging society could mean the economy stays recumbent.