Strengthening Germany as a Centre of Innovation

The sustainable strengthening of Germany as a business location is an essential prerequisite for stimulating private investment and innovation activity in the future. In his guest article in the monthly report of the Federal Ministry of Finance, ZEW President Achim Wambach writes about the relevant factors.

Debating location instead of economic cycle

Although the ZEW Indicator of Economic Sentiment, which reflects the assessment of financial market experts on economic development, rose for the eighth time in a row in March 2024, this came on the back of a very negative assessment of the situation. The economic expectations for 2024 are unfavourable: in its annual economic report, the German government predicts economic growth of just 0.2 per cent; the latest joint forecast by German economic research institutes is for 0.1 per cent. Against this backdrop, however, it would be misguided to remain mired in a debate about economic development. The drop in inflation and the ECB’s expected interest rate cuts will stimulate consumption and the economy. However, the structural problems go far beyond cyclical issues: with the energy transition and geoeconomic tensions, the German economy is facing fundamental upheavals. And the conditions for Germany as a business location are not good: in the Country Index for Family Businesses, for example, which was compiled by ZEW on behalf of the Foundation for Family Businesses, Germany now ranks only 18th out of the 21 industrialised countries surveyed.

Focusing on innovation in climate policy

The European Union aims to be carbon neutral by 2050, and Germany by 2045. However, the climate problem would not be adequately addressed if it were confined to simply meeting climate targets. Europe wants to play a pioneering role in climate policy. The world is less interested in whether Europe achieves its climate targets – that is beyond doubt – than in how these targets are achieved. Only if Europe succeeds in combining sustainability with prosperity will it become a successful model that can also be copied by poorer countries. Innovation is essential for this, and the conditions are good: the EU countries account for less than eight per cent of global emissions, but almost a quarter of the world’s researchers. A successful climate protection programme is also a successful innovation programme. This particularly applies to the German economy, which is one of the most innovative in Europe. Its strengths should be utilised to achieve market leadership in the technologies that are important for the energy transition.

Geoeconomics – “Technological sovereignty” as a driver of innovation

The COVID-19 crisis, the war in Ukraine and the political tensions between China and the USA have put issues surrounding security of supply back on the agenda. However, simply securing supply chains is not enough: it is of little help to become more independent in production today if technological progress takes place elsewhere. In order to be able to act independently and confidently in the future, “technological sovereignty” is required to keep pace with current research and development (R&D). In addition to managing its own dependencies, it will also be essential for Europe to be able to use its strengths to find good solutions to international disputes. Besides access to the single market, these are in particular the technological advantages that Europe has to offer. Finally, military procurement, which must be expanded in the context of geopolitical tensions, should be utilised for innovation to a much greater extent than has been the case to date. An innovative defence sector is a key component of technological sovereignty.

Shaping Germany’s innovative strength up for the transformation

Figure 1 shows the sectors in which Germany is particularly strong in terms of R&D. Companies in vehicle manufacturing, information and communication technology services, the electrical industry, the chemical/pharmaceutical industry and mechanical engineering in particular spend substantial amounts on R&D, with upward momentum over the past ten years. It is also noticeable that sectors such as the metal industry and mining have shown less innovation efforts over time.

However, Germany is not sufficiently prepared for the transformation in terms of innovation. Germany as a business location is weakening. What’s more, climate change and transformation require swiftness and adaptability. The German innovation model, rooted in thoroughness and cautious progress, seems ill-equipped to meet these demands. Innovation spending, especially by companies with over 250 employees, has indeed risen in recent years. However, the ZEW core indicators on companies’ innovation behaviour show that the proportion of companies with innovation activities has been declining since 2018.

Improving locational conditions for companies and skilled workers – Minimising burdens

ZEW company surveys show that, in addition to the shortage of skilled labour, regulatory barriers are among the most serious obstacles to innovation. The government has initiated a series of measures to improve the conditions for doing business in Germany: Bureaucracy Reduction Act I to Bureaucracy Reduction Act IV, Skilled Immigration Act and Growth Opportunities Act provide important impetus. However, this is not enough in view of the enormous transformation tasks facing the German economy.

Germany is a high-tax country in terms of corporate taxation (see also Figure 2). The Mannheim Tax Index determines the effective average tax burden for a hypothetical investment. In addition to tax rates, tax bases (e.g. depreciation and interest deductibility) are also taken into account. Germany’s tax burden was once in the middle of the pack. However, the tax cuts for companies in the USA, the UK and France since 2017 have pushed Germany into an inglorious top position. At the same time, however, the conditions for investment – good infrastructure, a reliable legal system, established cooperation between research institutes and industry, etc. – have not improved significantly during this period. For a country whose companies are so strongly integrated into the international economy, this situation is not sustainable in the long term. Tax rates are a key factor in the question of where companies want to invest.

Germany also has problematic peak values when it comes to the burden on employees. According to a study by the Organisation for Economic Co-operation and Development (OECD), Germany is at the top end of countries in terms of taxes and duties. However, highly qualified people tend to move to places where tax rates are low. These highly skilled professionals are needed in Germany, particularly in the innovative sectors and for start-ups.

Gearing funding programmes towards research and development

Germany supports companies and households in switching to climate-friendly technologies and subsidises the establishment of companies for greater security of supply in individual sectors.

However, with its focus on (green) production and expansion investments, the current funding framework falls short when it comes to the future viability of the German economy: R&D is not explicitly supported by these programmes. In addition, substantial funds are channelled into sectors that are not among the strongest in research in the German economy and whose value added is lower. In the future, Germany will continue to generate its prosperity in those sectors in which companies are particularly innovative and independently develop a competitive advantage. These must be strengthened during the transformation process.

One instrument to orientate the public budget more consistently towards sustainability is the future quota proposed by ZEW. This is intended to identify the share of the budget that is geared towards future rather than present benefits. Thankfully, this future quota has increased in recent years, from a good 14 per cent in 2021 to 16 per cent in 2023.

Expanding infrastructure investments

The sustainable strengthening of Germany as a business location is an essential prerequisite for stimulating private investment and innovation activity. The expansion and conversion of infrastructure is essential for this. The need for investment in infrastructure is massive. Current investments in electricity transmission and distribution grids, for example, fall far short of what is needed. Innovative financing concepts such as the amortisation account for the development of hydrogen grids must be further developed in order to provide the planning security required for private investment. The transformation of Germany as a centre of innovation requires new approaches.

This guest article first appeared in the BMF Monthly Report April 2024 (in German)