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IZA COMPACT – Special Issue November/December 2002 Seven Proposals for a Modern Labor Market Policy in Germany 1

An Improved Economic Framework for Increased Employment

The German unemployment problem is still awaitingthe implementation of desperately needed solutions.Since the 1970s structural unemployment has risen withevery recession. Contrary to most other developedcountries, the decrease in unemployment in a phase ofeconomic growth is weaker than its increase in the previousphase of recession. Moreover, the risks of unemploymentare not shared equally. Most likely to be affected are thelow-skilled and the elderly. For the latter in particular,layoffs often lead to long-term unemployment.

The persistence of unemployment indicates that thejob crisis in Germany is predominantly structural in nature.One major source of these structural problems aredisincentives put in place by labor market institutions.The expansion of the welfare state has, with the best ofintentions, created numerous rules protecting workers.In the process, policymakers have failed to ensure thatthe different labor market players – employees,unemployed, employers, unions and politicians – act inthe interest of society as a whole. Voiced demands alonewill not solve this problem. Likewise, the call for increasedjob opportunities for the elderly will ring hollow if thegovernment at the same time, through early retirementprograms, keeps supporting the idea of graduallyremoving elderly employees from companies. Jobopportunities in the low-wage sector cannot be created ifthe social safety-net regulations for the low-skilled makelegally employing these workers financially unattractive.Demands for moderate wage demands will be widelyignored if the government is willing to use labor marketpolicy instruments to compensate for the negativeemployment effects of excessive pay hikes.

The German Labor Market: A Construction Site for Reform

Seven Proposals for a Modern Labor Market Policy in Germany

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Stepping Towards Labor Market Flexibility

Education as a Key to the Labor Market

Meeting Demographic Challenges

Opinion

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Sonderausgabe – November 2002

Removing Work Disincentives

Reforming the Unemployment Insurance System

Reorganizing Active Labor Market Policies

Towards Decentralized Bargaining Procedures

COMPACT

The message is loud and clear: Economic policy needsto reshape the conditions for private market participantsso that they can once again operate efficiently. Labormarket and social policy have to be clearly separated inorder to overcome the current mingling of economicpolicy aims which has been detrimental for growth andemployment. Only under these conditions can the labormarket functions be improved in a way that would entaila substantial increase in employment.

This is the objective of IZA’s seven proposals for amodern labor market policy reform. They aim atimproved work incentives and a radical rearrangementof labor market policy institutions. At the core is thestrict separation of unemployment insurance and activelabor market policy. This is why the IZA policy proposalsgo far beyond those made by the Hartz commission toreform the Federal Employment Services (Bundesanstaltfür Arbeit). IZA’s elements of reform also provide impetusto a new understanding of collective wage bargainingautonomy, to a move towards increased flexibility oflabor relations, to responsible education policies, andto the adoption of adequate responses to thedemographic challenge.

It is not so much the lack of economic insight thatimpedes the healing process of the German labormarket, but rather the society’s lack of willingness forconflict. IZA’s reform proposals contain economicguidelines for a modern labor market policy. It is notimpossible to improve the policy framework for moreemployment. Implementing the proposals, however,will require a lot of courage from the policymakers inpower.

�� IZA presented its reform proposals for the German labor market to the public in Berlin on November 13, 2002.

C O N S I D E R I N G T H E F U T U R E O F L A B O RC O N S I D E R I N G T H E F U T U R E O F L A B O RCOMPACT

Special Issue - November/December 2002

2 An Improved Economic Framework for Increased Employment IZA COMPACT – Special Issue November/December 2002

Developing the Low-Wage Sector via Workfare

Abandoning the Single Wage Earner Model

Terminating Government Assistance for Early Retirement Schemes

Tapping Unused Labor Force Potential through Reforms of the Tax and Transfer System

By international standards, labor market participation inGermany is relatively low. Thus important labor marketpotential remains untapped. Individuals who do not havea prospect of returning to the labor market invest little inhuman capital. After withdrawal from the labor market,previously acquired human capital lies idle and degenerates.Increased labor supply can be the engine for economicgrowth and employment success.

Experience from other countries shows that there isno immediate trade-off between high labor forceparticipation and low unemployment. The size and the

structure of the labor force are not merely a mirror imageof unemployment, but they are also strongly influencedby institutions. In Germany, the tax and transfer systemcreates several negative work incentives, which contributeto unemployment, particularly among unskilled, female,and elderly workers. To a certain extent, the unfavorableposition of these problem groups on the labor market isdue to relatively low participation.

Therefore, any kind of direct or indirect subsidyprovided to individuals withdrawing from the labormarket should be abolished.

The current German system of livelihood protectionthrough unconditional welfare benefits (Sozialhilfe)impedes the establishment of a low-wage sector. Formany of the unskilled, the gap between the achievablewage income and the income attainable from welfarebenefits is so small that taking up a job is simply notattractive. Companies, unable to fill their vacancies due toa lack of interest in low-paid work, have graduallyeliminated job opportunities for the unskilled.

The adoption of workfare, i.e., the concept oflivelihood protection through labor, can solve theincentive problem associated with the provision of socialwelfare benefits. All individuals who qualify for socialtransfer payments, but are able to work, should only

receive full benefits in exchange for taking up publiclyprovided, socially useful employment. The placementprocess could be handled by workfare agencies created inthe wake of reforms of unemployment assistance andwelfare, to be discussed below.

The obligation to work in order to receive welfarebenefits would make jobs that pay just a little more thanthe level of social transfers attractive again. For the sameamount of working hours invested individuals couldachieve higher net earnings. Most transfer recipients whoare able to work would then return to the labor market.As a result, the pay scale would be extended at the lowerend. This would constitute an important contributionto labor market flexibility.

Abandoning the Single Wage Earner Model

Developing the Low-Wage Sector via Workfare

Removing Work Disincentives1

While women have gained ground in the area ofeducation, they still participate substantially less frequentlyin the labor market than men. The labor market thusloses vital human capital. Even today the social role modelseems to hold that mothers withdraw from the labormarket in order to raise their children. This is not onlydue to a lack of child-care facilities. German tax law andsocial insurance regulations contain several elements thatare based on the traditional model of the single

breadwinner. As a result, if the spouse takes upemployment, the marginal tax on her income is oftenvery high.

As far as income taxation is concerned, in particularthe existing system of joint income splitting for marriedcouples (Ehegattensplitting), which means that for taxpurposes fifty percent of the couple’s income is assignedcounterfactually to each spouse, creates negative workincentives. The current splitting rule generates a tax


Terminating Government Assistance for Early Retirement Schemes

advantage that is positively correlated with the incomedisparity between the two partners. Consequently, it isrelatively unattractive for the household to earn a secondtaxable income since it first has to compensate for theloss of the splitting advantage.

To reduce the high marginal tax rate on second earnerincomes, which mostly harms women, the current practiceof income splitting should be replaced by a system thatcould be referred to as real income splitting (Ehegatten-realsplitting), which is very similar to the current taxtreatment of divorced couples. Under this concept,spouses as a general rule would be taxed separately on thebasis of their respective labor income. In cases where onespouse does not work or earns little, however, thebreadwinner would be allowed to assign a certain amountof subsistence payments to the partner. This (notional)alimony payment would be tax deductible, thusguaranteeing the tax exemption of basic living earnings.

Real income splitting would lower the marginal taxrate on the second earner’s income, creating incentives totake up employment. At the same time, the systemimposes a higher marginal income tax rate on bread-

winners, whose labor supply, however, tends to be ratherinelastic. Therefore, the implementation of a real incomesplitting concept could generate additional tax revenue,which should be used to support families, e.g. throughimproved child-care provision.

As far as social insurance regulations are concerned,the current practice of free coinsurance of spouses shouldbe abolished. This especially applies to statutory publichealth and long-term care insurance, which offer insuranceof non-working family members at no extra premiumfor the breadwinner. In this situation, spouses who takeup a job have to pay contributions, but this does not leadto better insurance coverage. As a result, statutory healthand long-term care insurance contributions are regardedentirely as a tax on labor income.

Likewise, entitlement to survivor’s pensions withoutpaying contributions has become obsolete with betterlabor market opportunities for women. Guaranteeingpensions for the surviving spouse at no cost reducesincentive to build up an own retirement account throughgainful employment.

In Germany, the labor market prospects of elderly workersare particularly dim. Partly due to age-related productivityrisks, partly due to seniority wages, elderly workers arecomparatively expensive to employ. Therefore, employershave incentives to lay off the elderly members of theirworkforce first. This problem warrants concerted actionon the part of trade unions and employers.

Current firing regulations further reduce theemployment opportunities of elderly workers. Accordingto German labor market laws, employers who need to layoff part of their workforce have to consider the socialconsequences of a layoff. Therefore layoffs often do nottarget the least productive employees but those who havethe option to leave into early retirement.

The government currently supports early retirementthrough different channels. Early exit from the labormarket is encouraged directly via financial assistance ofpart-time work for elderly workers and the specialopportunity of early retirement in the case of long-termunemployment. Reforms already enacted envision thatthese specific early retirement programs will expire after atransition period. This period, however, should beshortened as much as legally possible. Moreover, in orderto prevent people from circumventing hurdles to earlyretirement on a health track, early retirement should no

longer be granted to unemployed with only partialincapacity to work.

Indirect incentives for early retirement arise from thefact that the cut in pension benefits for those who retirebefore reaching the statutory retirement age is, from anactuarial perspective, too small. Put differently, longeremployment is financially unattractive, as the gain inpension does not outweigh the additional contributionpayments. Consequently pensions losses for early retireesshould be increased so that they become actuarially fair.By the same token, individuals who work beyond thelegal retirement age should be rewarded with a higher,actuarially fair pension increase. In order to take intoaccount changes in payroll contribution and replacementrates, as well as the development of survival rates, theactuarial pension adjustment factors should be re-evaluated on an annual basis.

Eliminating incentives for early retirement, at least inthe medium term, will help reduce unemployment ofelderly workers. The prospect of a longer working lifemakes it more attractive for employers, but also foremployees, to invest in human capital formation andsuitable workplaces in order to preserve the employabilityof elderly workers up to the statutory retirement age.


Unemployment insurance in Germany is organized bythe Federal Employment Services (Bundesanstalt für Ar-beit). This public agency manages the payment ofunemployment benefits, but at the same time it engagesin labor market policies, such as job creation programsand training programs. These measures can hardly bereconciled with the pivotal aim of unemploymentinsurance, which is to guarantee income security during acertain period of unemployment in order to make efficientjob search possible. In fact, the substantial currentengagement of the Federal Employment Services in activelabor market policies primarily pursues broader economicobjectives within the scope of structural and regionalpolicies. Funding these broad aims through payrollcontributions is inappropriate since it puts the fiscalburden entirely on labor.

One explanation for the far-reaching activities of theFederal Employment Services in the realm of labormarket policies is its organizational structure. The self-governing body of the Federal Employment Services isfilled with an equal number of policy makers, employersand union officials whose interests are not necessarilyidentical to those of the unemployed. In fact, theimplementation of labor market policies by the FederalEmployment Services interferes in many cases with the

Strengthening the Responsibility of Individuals and Collective Bargaining Partiesfor Labor Market Activity

outcomes of the collective bargaining process, backingwage agreements that are detrimental to employment andrelieving unions and employers’ organizations of theirsocial responsibilities. It therefore seems essential thatthe Federal Employment Services be transformed into atruly autonomous body.

The current level of benefits provided by unemploy-ment insurance in Germany also warrants a closer look.The core objective of providing adequate income duringa period of unemployment must be reconciled with thepotential negative impact on search intensity. A featureof the present unemployment insurance system is agenerous income replacement rate in combination with avery long benefit entitlement duration. The latter isvirtually unlimited because tax-financed unemploymentaid (which is still rather generous) automatically startsafter unemployment benefits paid from contributionsexpire. The amount of unemployment aid is typicallyhigher than the level of welfare benefits so that theproblem of a welfare trap, which locks unskilled workersin unemployment, appears aggravated. On the whole,the generous social protection of the unemployed mostlikely increases the level of unemployment in Germanyby prolonging the average duration of an unemploymentspell.

Reforming the Unemployment Insurance System

Institutional Separation of Insurance and Job Placement

Autonomy of Unemployment Insurance

“Two + Twelve Concept” – Waiting Period and Shorter Unemployment Benefit Duration

Benefit Entitlements Linked to Job Search Intensity

Merging of Unemployment Aid and Social Welfare

In the future, the Federal Employment Services shouldfocus exclusively on providing insurance against incomelosses in case of unemployment. This implies that theresponsibilities for job placement as well as other measuresof active labor market policy have to be taken over by

Institutional Separation of Insurance and Job Placement

other institutions. These activities should be organizedthrough private, competitive firms, which would thenserve all job-seekers instead of just those who have paidcontributions to the unemployment insurance.

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The unemployment insurance administered by theFederal Employment Services must not rely ongovernment subsidies to balance its budget, but solelyon revenue derived from payroll contributions. Thiswould keep the financial burden on labor fromunemployment insurance at the lowest possible level.Since non-insurance tasks no longer strain the budget of

Autonomy of Unemployment Insurance

the Federal Employment Services, contribution rates forunemployment insurance would most likely beconsiderably lower than today. Parallel to fiscalindependence, the transformed Federal Employment Ser-vices, should become an independent self-governed bodyabandoning the representation of political pressuregroups on its board.

As a means to avoid windfall gains, no unemploymentbenefits should be granted during the first two monthsof an unemployment spell. (Those unemployed withoutsufficient savings to sustain this period could receive non-bureaucratic help in the form of a repayable governmentloan.)

In order to increase job search intensity, transfersshould not run for more than a year without exception,so that unemployment benefits would expire no laterthan 14 months after entry into unemployment. For those

“Two + Twelve Concept” – Waiting Period and Shorter Unemployment Benefit Duration

individuals who continue to be unemployed after thisperiod, the system of livelihood protection throughworkfare would take over. In addition, workers may beprompted to buy additional private insurance against theincome risk associated with long-term unemployment.

The proposed two+twelve concept, which impliescutting the existing maximum benefit duration quitesubstantially in some cases, especially for elderly workers,would make it possible to maintain the currentreplacement rate of unemployment benefits.

The unemployed should receive insurance benefits onlyif they are in fact searching for a job. Recipients of unem-ployment benefits should therefore be obliged tosubstantiate their job search effort on request by the Start

Benefit Entitlements Linked to Job Search Intensity

Centers. Job-seekers who fail to show credible document-ation of their search activities should be subject to areduction and, after repeat failure to comply, a terminationof their unemployment benefits.

Unemployment aid, which is paid to the long-termunemployed after their unemployment benefits haveexpired, is not an integral element of unemploymentinsurance, but rather a welfare program to guarantee asecure livelihood. Consequently it is funded through taxesrather than payroll contributions.

Since unemployment aid runs parallel with the systemof welfare benefits, however, the unemployed are treatedunequally. Those long-term unemployed who have oncereceived unemployment benefits often receive highertransfer payments than those who have not had access tounemployment benefits (e.g. because they were notemployed long enough prior to unemployment).

Merging of Unemployment Aid and Social Welfare

Securing the livelihood should exclusively be themission of the social welfare system, organized accordingto the workfare principle. Unemployment aid shouldtherefore be abolished as soon as possible. Withunemployment aid and welfare benefits merged, the fiscalresponsibility for providing the means to securelivelihood should be transfered from the municipalitiesto the federal government and the states. Thus thefinancial burden would shift to those federal levels thatare responsible for permanent unemployment andpoverty.


As soon as possible, a nationwide network of publicStart Centers should be installed that would replace thehitherto competing local employment offices and jobassistance departments of the welfare offices. These StartCenters would not engage in job placement activities, butact for all job-seekers as the first point of contact, withthe task to categorize them according to a standardizedpoint system designed to evaluate job placementprospects. The profiling statement would be taken toone (or several) private job placement agencies by the job-seeker.

“Start Center” as a Central Point of Contact for the Unemployed

“Start Center” as a Central Point of Contact for the Unemployed

Private Placement with Government Bonus Payments

Placement Co-Financing by the Newly Employed

Market-Based Assignment to Labor Market Programs

Evaluation of the Placement Bonus Incentive System

Establishment of Service Agencies

One of the characteristics of current labor market policyin Germany is that it is very much dominated by thepursuit of social, structural or environmental ends. Henceswift re-integration of the unemployed into the labormarket, the ultimate goal of labor market policy, oftentakes a back seat. The overlap of different policy objectivesmakes monitoring of the implemented policies difficult.As a result, there is a serious lack of efficiently designedpolicy tools and uncertainty about the optimal scope ofgovernment intervention. A prerequisite of successfullabor market policy in the future will be that decisionmakers once again clarify their goals, and that any objectivenot directly related to the labor market is returned to itsproper policy realm.

On the institutional level, the co-existence ofemployment and welfare offices with labor marketresponsibilities creates inefficiencies through overlap.Moreover, the system encourages that the fiscal burdensfrom long-term unemployment are shifted back and forthbetween the welfare offices, financed by the municipalities,and the employment offices, financed by the federal statevia the Federal Employment Services (Bundesanstalt fürArbeit). For example, it frequently happens that muni-

Restoring Employment Success as the Core Objective of Labor Market Policies

cipalities, in order to reduce the welfare bill, tem-porarilyplace welfare recipients in sponsored jobs that renewentitlement unemployment benefits. If fiscalconsiderations and not reemployment success start todominate the objectives of job creation programs, this iscertainly to the disadvantage of the individuals affected.

At present, mostly semi-public education providersor employment agencies (Beschäftigungsgesellschaften) do thedesign of labor market initiatives. They sell their productto employment and welfare offices, which are more oftenthan not evaluated on the basis of their success in spendingtheir budget completely, rather than in enhancingemployment. Clearly there is a need to first formulateprecise labor market requirements before a system of cost-benefit controls can be installed. For this to be effective,the suppliers of labor market programs should beinstitutionally separated as far as possible from the publicbodies demanding them.

Finally, labor market policy should be used to developcurrently untapped employment opportunities. InGermany, the area of services to private households inparticular bears substantial employment potentials thatappear well worth targeting.

Under this system, welfare recipients looking foremployment would receive special attention. As a rule,the Start Centers would refer them to a local workfareagency providing socially beneficial work. At the same time,welfare recipients may also seek the additional service ofa job placement agency.

The core tasks of the Start Centers would be to profilethe unemployed and to manage the financial issuesconnected to the job placement procedure (includinghandling the cost of necessary measures to improveemployability). In addition, they should provide certain

Reorganizing Active Labor Market Policies3


The Start Centers should pay the job placementcompanies for each successful placement according to apayment scheme depending on perceived placementdifficulty as indicated by the profiling statement. Thisprocedure would prevent job placement agencies fromengaging in cream skimming. The federal governmentand the states should fund the Start Centers so that theystay financially independent from the placement agencies.

Private Placement with Government Bonus Payments

The placement agencies should only be rewarded infull if they place individuals in stable jobs. The placementreward should therefore be paid in twelve monthly ratesconditional on continuation of employment. Thus itcan be guaranteed that the placement agencies are alsoconcerned about the quality of job matches.

For individuals who find employment via a placementagency, it should be mandatory to bear part of theplacement costs. Preferably the size of the co-paymentwould be related to earnings in the new job. It should bepaid in one installment after a period of six months,which implies that the worker contributes only if he orshe is brought into stable employment. The co-paymentwould therefore prevent abuse of the award systemthrough phony job placements. In addition, individual

Placement Co-Financing by the Newly Employed

initiative is encouraged, for those agents who manage tofind employment without outside help could save theco-payment.

Job-seekers and placement agencies should be free tonegotiate the exact amount of the co-payment withincertain limits. This practice would encourage competitionamong the placement agencies, which would use the priceof their service to the job-seeker as a marketing parameter.

Market-Based Assignment to Labor Market Programs

If a placement agency concludes that the employmentprospects of a job-seeker can be effectively increasedthrough qualification, it will offer participation in specificlabor market programs to its client. (Participation wouldnever lead to an extension of unemployment benefits.)For their services, the providers of labor marketprograms would receive a certain share of the placementaward from the placement agencies, which is subject tonegotiation. Since this money is only payable if theparticipant becomes reemployed, this would lead to amore success-oriented program design.

Program providers would make their profits fromtheir share in the placement rewards. The costs of thequalification measures, on the other hand, would be

carried by the Start Centers, except for a certain share to beborne by the program participant in order to strengthenindividual responsibility with regard to program choice.The size of the co-payment, payable only after returninginto employment, would particularly depend on the to-tal cost of the selected program. This orientation wouldenhance cost efficiency, given that agents are free to rejectmeasures proposed by the placement agency (and proposemeasures they themselves deem suitable).

This framework would strengthen the competitionamong the providers of qualification measures. Onlythose labor market programs that effectively improve theparticipant’s job placement prospects would have a chanceto survive.

administrative services. First, they should report cases tothe unemployment insurance agency so that unemploy-ment benefits can be granted. Besides, the job centersshould continually monitor the unemployed. If theydiscovered reasons to cut individual benefit payments,

for instance because a job-seeker receiving unemploymentbenefits fails to prove searching actively for a job, or becausea welfare recipient does not cooperate with a workfareagency, they would have to report these cases to theresponsible institutions to take action.


Establishment of Service Agencies

Evidence suggests that services to private householdsconstitute a major source of employment stillunderdeveloped in Germany. Improved organization ofthis particular labor market could not only help legalizethe black market activities in this domain, but alsosubstantially expand demand. It is therefore useful toimplement professional service agencies for the

registration and placement of household aids, whichcould manage demand fluctuations, job flows, vacationand sickness replacements, etc. more easily than theindividuals who supply or demand private householdservices themselves. In particular, specialized serviceagencies would manage to merge several part-time activitiesinto a full-time profession.

The proposed reorganization of institutions for labormarket policy is firmly based on the idea to create checksand balances among the interacting parties througheconomic incentives. But since the award for successfulplacements (as a function of the profiling result) must beset by the Start Centers a priori, the question of the opti-mal design of prices warrants careful consideration. Since

operating with the wrong award scheme could lead toinefficient placement, continuous scientific evaluation ofthe generated reemployment dynamics is crucial. If doubtsregarding the economic efficiency of the placement processand of the assignment to labor market programs arise,the award scheme has to be adjusted on the basis of theevaluation results.

Evaluation of the Placement Bonus Incentive System


IZA Proposal for Reorganizing Active Labor Market Policies

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Abolishing the General Validity of Wage Agreements

Redefining the Favorability Principle

Giving Priority to Internal Company Agreements

Towards Decentralized Bargaining Procedures

Misconceptions of Collective Bargaining Autonomy Put Jobs at RiskThe notion of collective wage bargaining autonomy isheld in high esteem in Germany. It implies that workconditions are regulated by employers and employeeswithout governmental intervention. The GermanConstitution protects collective bargaining autonomythrough the freedom of coalition-building. The samefreedom, however, includes the right not to belong toany bargaining party. As a general rule, collectiveagreements therefore should apply only to members ofthe bargaining parties.

The current interpretation of the constitution allowsfor the violation of this principle for the sake of the“common interest”, which has led to the possibility thatthe government declares certain parts of collectivebargaining agreements to be generally valid. From theeconomist’s viewpoint, what is publicly regulated in thename of common interest must comply with a strict

criterion – government intervention must lead theeconomy closer to efficiency than an open competitionbetween the employers and employees who are tied tocollective wage bargaining agreements and those who arenot. Usually this will not occur because wage interventionsand restraints on individual flexibility tend to causecompensatory shifts towards activities in the shadoweconomy and capital flight, which have negative effectson employment and income. Moreover, it is necessary totake into account the violation of interest for those whoclaim their freedom not to join a collective agreement.

At present, many German decision makers take thestance that collective bargaining autonomy requires theprotection of bargainers against competition from out-siders. This is, however, a misguided interpretation. Ifdecentralized bargaining turned out to be more efficient,this would certainly be in the common interest.

Through declarations of general validity (Allgemein-verbindlichkeitserklärungen), which are used by thegovernment to extend collective bargaining agreementsto non-organized employers and employees, policymakerssignificantly interfere with the needs for flexibility on theGerman labor market. To the extent that they practicallyimpose minimum wages, they are a threat to employment,

Abolishing the General Validity of Wage Agreements

in particular in labor-intensive sectors. They may also leadto activities in the shadow economy.

Considering the potential negative economicfeedbacks, the restraints put on intra-firm decision-makingby declarations of general validity of collective agreementsdo not seem justified. For the most part, they shouldthus be abolished.

According to the German Works Constitution Act (Be-triebsverfassungsgesetz), corporate management and workscommittees are generally not allowed to negotiateagreements over issues that are subject to collective wagebargaining agreements. This right is only given if thecollective bargaining agreement contains an opening clause,or if the agreement at the firm level is more generousthan the collective agreement. This is referred to as the so-called favorability principle (Günstigkeitsprinzip).

So far, courts have interpreted the favorability principlein a strictly material sense. This interpretation completely

neglects the question of individual employment risk,which is equally important from an economic stance. Thusemployees do not have the option to trade higher jobstability for wage cuts (or rather wages growing at a slowerpace).

Since the current interpretation of the favorabilityprinciple therefore may only contribute to unem-ployment, an economically more meaningful defi-nition of the concept should be installed thatincludes the aspect of job security.

Redefining Favorability Principle

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The Works Constitution Act generally declaresdecentralized agreements at the firm level as void unlessthe corresponding collective bargaining agreementcontains a relevant opening clause (Öffnungsklausel). Thisconstraint on decentralized bargaining severely limits thepossibility of implementing agreements that take intoaccount the economic situation in the individual firm.

Nonetheless, it is increasingly the case that employersand employees reach firm-specific agreements even if thispractice is basically illegal. This may indicate that individualemployees are willing to put a larger weight on job security

Giving Priority to Decentralized Bargaining

than trade unions bargaining over collective agreements.In order to legalize this practice, agreements reached atthe firm level should, as a rule, legally dominate collectivebargaining agreements. This would constitute a reversalof the current situation – a collective wage bargainingagreement would only be relevant if no companyagreement existed.

In the medium term, the relevant paragraph shouldbe completely erased from the German WorksConstitution Act. This would allow for free competitionbetween collective and decentralized agreements.


Replacing Layoff Protection with Severance Pay

Abolishing the Right to Switch to Part-Time Work

Auctioning Off Temporary Immigration Certificates

Eliminating the € 325-Jobs

Layoffs are heavily regulated in Germany. Since there existsa monetary equivalent for legally guaranteed layoffprotection, an employer can choose to pay a worker somefinancial compensation for dismissal. But the costsassociated with this practice reduce hirings, especially ofapplicants who may not be able to live up to the employer’sexpectations in the long run. Since this is often true forolder job-seekers, they are particularly prone to long-termunemployment.

Under the current law, a layoff is only legitimate incases of gross misconduct or for operational reasons.According to the common interpretation by the courts, alack of motivation to work, for example, is not consideredgross misconduct. Employers who want to get rid ofunproductive employees are thus forced to fabricate areason for dismissal. This often results in lawsuits thatcarry monetary risks.

The current system of layoff protection should bereplaced by legal rules for mandatory severance pay.Employees would then receive a certain percentage oftheir salary, differentiated according to job tenure, as a

The ability to adjust to the ever changing economicenvironment is a prerequisite to business success.However, government regulations – even though in goodintention – often impede flexible adjustment. It istherefore crucial to weigh legitimate interests against eachother and to continuously evaluate their validity. Enhancedflexibility should always be the choice if it is likely tocreate more jobs than it would destroy.

Current labor legislation in Germany is characterizedby rigid protection of existing employment relationships.This limits the scope for adjustment within companies.Among the most constraining factors are the rules governinglayoff protection, co-determination, part-time work options,and temporary employment. Nonetheless, there is a strongdemand for flexibility, which leads to other forms ofemployment such as outsourcing, tax-exempt minoremployment, or shadow economic activities.

Antagonism between the Legal System and Labor Market Requirements

Employment protection is an economicallyfeasible method to increase efficiency because itguarantees employees a return on their investmentin human capital that they would not have madeotherwise. At the same time, employment protectionhas a negative impact on the employers’ propensityto hire new workers. There is a need for a morebalanced relationship between the protection ofworkers and adjustment needs of firms.

There is also a need for enhanced flexibility of theGerman labor market because shortages of high-skilledworkers cannot be filled with native workers despite highunemployment. Even the new immigration law will noteliminate the bureaucratic impediments to temporarylabor immigration. Allowing a larger number of labormigrants for a limited time could help to deal adequatelywith short-term labor market disequilibria.

Replacing Layoff Protection with Severance Pay

compensation for dismissal. Since a reason for dismissalwould not usually be required (of course, severance paywould not apply in cases of gross misconduct), thissystem could substantially reduce the probability oflawsuits.

Currently, most of these legal disputes end up with asettlement that leaves both parties with a share of thelegal costs. Therefore, the severance pay system wouldbenefit employers and workers alike, if the legal compen-sation scheme is moderate. While the new regulationswould result in more layoffs, they would also increase thepropensity to hire. The net result would be more jobs.At the same time, employers would no longer have toaccount for social criteria when laying off workers duringa recession, which previously has often led to inefficientfirings. Layoffs for operational reasons would be basedsolely on the productivity of the employee.

A reform of layoff protection should be favoredover an increase in fixed-term contracts as it makesemployers and employees more inclined to invest in hu-man capital.

Stepping Towards Labor Market Flexibility5


The present law gives every full-time employee the rightto switch to a part-time job. Under certain circumstances,the employer can deny this right for operational reasons.In practice, this regulation restricts employers’ flexibility.The cost of dividing a job in half is usually higher thanthe gain from having two part-time employees. In orderto fill the new position, the employer will usually have tofind someone who is also willing to work part-time.

Given the present shortage of high-skilled labor inGermany, additional restrictions on working hoursincrease the affected firm’s competitive disadvantage.Moreover, the right to part-time work constitutes a hiringobstacle for workers who are likely to exercise this right –primarily young women. This regulation should thereforebe abandoned completely.

In some dynamic sectors of the German labor market,the labor supply of natives does not keep pace with thefast-growing demand. Temporary labor migration couldhelp overcome short-term labor market imbalances thatimpede economic growth. In order to identify the fieldsof temporary labor shortages and to ensure an efficientselection of the best-suited immigrants, each year a limitednumber of residence and work permits should be auct-

Auctioning Off Temporary Immigration Certificates

ioned off to employers who seek to fill vacancies temp-orarily with labor immigrants. These auctions would skimoff part of the employers’ profits from immigration,which in turn could be invested in education and trainingof unemployed natives. The new immigration law leavesit up to government agencies to allow temporary laborimmigration on a case-by-case basis. An auction systemwould be far superior in solving the information problem.

With the introduction of minor jobs (with monthlyearnings of less than € 325) that are exempt from socialsecurity contributions, policy makers have tried to meetthe demand for flexibility rather than eliminating thesources of inflexibility. These jobs are an exception fromthe ability-to-pay principle of income taxation and theequivalence principle that should govern social securitycontributions.Morevover, the current regulations for minoremployment reduce flexibility further since secondary wage

Eliminating the € 325-Jobs

earners face an income loss when exceeding the monthlyearnings threshold of € 325. Consequently, jobs that paybetween € 325 and € 800 a month have been all buteliminated. This problem could be solved – albeit onlywith high fiscal costs – by gradually raising payrollcontribution rates at the lower end of the earnings distri-bution. However, the proposals to enhance labor marketflexibility and the introduction of real income splitting fortax purposes would make the € 325-jobs redundant.

Abolishing the Right to Switch to Part-Time Work


Education as a Key to the Labor Market6

Expanding Pre-School Education, Introducing Child-Care Vouchers

Modernizing the Dual System of Vocational Training

Implementing Preventive Measures to Secure Human Capital

Modernizing the System of Higher Education

Creating and Securing Human Capital

It should not have taken the OECD’s PISA Study todemonstrate that the German education system is in needof reform. The confrontation with an increasinginternationalization of labor markets reveals that theeducational institutions in German have lost some oftheir power to compete. Decision makers, it seems, havestill not fully realized that human capital formation is thekey to labor market success. This is reflected, for instance,by a shortage of educational child-care facilities, a highregional variance in school performance, a long durationof schooling and training, and a large share of unskilledworkers in the labor force.

Education policy must not only aim at theaccumulation of more and more up-to-date knowledge.Strong emphasis should be placed on fostering theacquisition of learning ability, i.e., learning how to learn.It is now well understood that the foundation for thisability is best laid in early childhood, but school curricula

should also target the goal of developing the capacity oflifelong learning.

Educational reforms with the aim to improve labormarket performance must also seek to create equalopportunity for different social classes. One of theimportant messages contained in the PISA study is thatexisting talent is wasted in Germany since access toeducation is unevenly distributed among the population.Disparities in employment prospects and potentialincome are thus inherited from one generation to thenext.

While government action in the educational sector iscertainly justified, it is also true that individuals must takethe ultimate responsibility for the investment in humancapital formation. Therefore, it is also necessary tostrengthen the allocation of education resources throughthe price mechanism so that the cost-benefit aspects ofhuman capital formation becomes more transparent.

Expanding Pre-School Education, Introducing Child-Care Vouchers

The ability and the willingness to learn are shaped to alarge extent in early childhood. Therefore learning shouldbe encouraged at a very young age by offering child-carefacilities with adequate educational programs to all childrenaged two and older. Higher quality of pre-school educationwould help create the basis for school performance and,in the long term, labor market success.

This proposal requires expanding the supply ofkindergartens substantially. The additional tax revenuegenerated by the transition from joint income splittingto real income splitting for married couples, for example,could be used to finance this expansion of pre-schooleducation.

As a rule, it is more efficient if government supportfor education centers on subsidizing the subject (the child)rather than on subsidizing the object (the education facility)

as is the current practice in Germany. Therefore, publicfinancing of kindergartens should to a large extent bereplaced with vouchers given to parents. To addressdistributional concerns, the value of the vouchers may benegatively related to household income. With a systemof regressive vouchers, parents would continue to sharethe cost of a kindergarten slot, but competition amongthe providers of pre-school education would be increased.In particular, kindergartens would then have to adjustthe quality of their services, e.g. the hours of operation,to meet the demand of parents, who are free to leave thevoucher at the facility of their choice. In this system, themain task for the government would be to certify pre-school institutions that, by meeting certain educationalstandards, are eligible for receiving parents’ vouchers.


Implementing Preventive Measures to Secure Human Capital

Modernizing the System of Higher Education

Modernizing the Dual System of Vocational Training

Germany’s dual system of vocational training is one ofthe strengths of the German labor market and should bemaintained, albeit in a modernized form. In order toprepare apprentices for technological innovations andrapidly changing professional requirements, the focus ofvocational training has to shift back to the core occup-ations. At the same time, to keep vocational trainingattractive for employers, it is necessary that they can extracta higher rent from training as they have more time toteach firm-specific knowledge.

A change in vocational training curricula could correctthese issues. First a general part of classroom trainingshould teach the core qualifications required for a limitednumber of broadly defined occupations. This generaltraining part of the apprenticeship program should bedesigned to occupy not more than fifty percent of theapprenticeship period. The other part of theapprenticeship could then be devoted mainly to in-company teaching of firm-specific skills.

In the current situation, workers tend to invest too littleto maintain and enhance their human capital. This is notonly due to the lack of information on the (short) half-life of one’s own knowledge. On-the-job training oftenis not fully rewarded because the qualifications achievedare not transparent to future employers. In-companytraining courses therefore should receive some sort ofcertification. In order to give workers in small andmedium-sized firms better opportunities to enhance theirhuman capital, improved availability of external trainingprograms spanning across firms is recommended. In orderfor high-skilled workers to receive high-quality furthertraining, universities should offer more courses (subjectto enrolment fees) especially targeted at this audience.

The generous benefits provided by the welfare statein the case of unemployment also discourage workersfrom sufficient human capital investment on private in-itiative. In fact, many workers participate in trainingprograms only after they have become unemployed. Sinceeducational programs in unemployment are often ratherexpensive and of dubious effectiveness, additionalincentives for private training initiatives on-the-job shouldbe created. For instance, if placement fees are installed inthe future, part of the co-payment required from thereemployed worker could be waved for those who canprove that they have regularly participated in trainingprograms before becoming unemployed.

At present, university education in Germany is basicallyprovided free of charge. To improve universities’orientation toward the requirements of their students,tuition fees should be universally introduced. This wouldnot only help universities to gain financial autonomy(allowing them, for example, to offer more incentives tomotivate faculty members), but it would also guaranteethat students consider the cost and benefits of their studiesmore carefully. In order to ensure equal access

opportunities, student loans should be offered to allapplicants, in addition to scholarships for gifted students.The system of student loans could be designed similarto the existing loans given to economically disadvantagedstudents at the end of their university career.

In addition, to broaden the financial basis of theuniversities, it is useful to set incentives for privatedonators, by changing the rules concerning inheritanceand foundation endowment accordingly.


Systematic Funding of Social Insurances

Taking Pension Reform a Step Further

Raising the Legal Retirement Age

Creating Competition in Health and Long-Term Care Insurance

Introducing a Point System for Immigrants

Addressing Demographic Challenges7

In Germany, the share of the elderly will increase stronglywhile the population is shrinking rapidly. It has beenpredicted that Germany’s labor force will have droppedsubstantially by the end of the decade. The economicimplications of this trend are difficult to predict. Adeclining labor supply, however, is likely to result in slowergrowth. If productivity improvements fail to counteractthis trend, then GDP per capita could fall.

Demographic aging also puts a strain on publicbudgets. Government spending per capita is likely toincrease because individuals who have left the labor forceare typically recipients of net transfers from the public

Labor Market Risks from Demographic Trends

coffers. The aging process will have a particularly strongnegative impact on the different branches of statutorysocial insurance that cover risks typically increasing withage, i.e., the statutory pension, health care and long-termcare insurances. As these insurances offer (defined)benefits which are financed on the basis of a pay-as-you-go system, there is the serious danger of a substantialincrease in payroll contribution rates in the future. Sincecontributions to a pay-as-you-go system contain animplicit tax on labor, this would create negative workincentives, which could aggravate the labor shortage dueto demographic changes.

Systematic Funding of Social Insurances

Contributions to mature pay-as-you-go systems are a burdenon labor. In the aging German society, the share of thecontributions to the statutory social insurances that istantamount to a tax on labor because the return to thesecontributions is less than the return achievable on the capitalmarket will increase. This creates negative work incentives ora trend toward insurance-free, if perhaps less productivejobs. Moreover, if the employers cannot shift their paymentof insurance contributions entirely onto the workers, theyhave to bear part of the cost – and decrease their labor demand.

To prevent employers and workers from resorting toinefficient insurance-free forms of employment, socialinsurance regulations should be changed so that all laborearnings are subject to contributions. Besides, the numerousnon-insurance benefits should be properly financed by taxes.Contributions would then be raised only for their originalpurpose and could be lowered to the level required to financethe insurance benefits. This would keep the implicit tax onlabor as small as possible under the pay-as-you-go system.

Even after the pension reform of 2001, the replacementlevel of mandatory public pensions in Germany remainstoo high to avoid a substantial increase in contribution ratesunder demographic pressure, beyond the level that has beenpromised by policy makers. In fact, the enacted formula toreduce replacement rates over the long term does notadequately respond to the demographic strains on pay-as-you-go financing.

To stabilize contribution rates to Social Security, futurepension levels should first be tied to the development ofthe average length spent in retirement. This reform wouldcope with the impact of rising life expectancy and early

retirement. Second, individual pension levels should be scaledaccording to the number of children. After all, the gene-rational contract not only depends on contributions, butalso on offspring to provide future contributions. Pensionsshould therefore be cut for retirees who did not raise children.The money saved by not having children helps theseindividuals compensate for a lower retirement income.

In addition to income from the public pension insurance,private pension plans, just introduced on a voluntary basis,should become mandatory so that sufficient retirementincome is guaranteed despite falling public pension levels.The obligation to build up a private pension account would

Taking Pension Reform a Step Further


Creating Competition in Health and Long-Term Care Insurance

Introducing a Point System for Immigrants

prevent free-riding by those who rely on the expectation thatsociety will take care of them. The government should setincentives to save into private pension plans by grantingdeferred taxation. The practice of matching private savings

with public subsidies, established by the Pension ReformAct of 2001, however, should be abolished. The fundscurrently used for this complex subsidy scheme shouldinstead be put into servicing the public debt.

Over the last decades, the average lifespan spent in retirementhas increased substantially due to increased life expectancy.Since today’s retirees are much healthier than those of thepast, the German statutory retirement age of 65 is no longerjustified by reasons such as physical incapacity or constrainedproductivity. The retirement age should therefore be graduallyincreased to 70 within the next two decades. Flexible entryinto retirement could be maintained by allowing individualsto retire earlier if they accept benefit cuts amounting to theactuarial value of forgone contributions. Given theimportance of direct taxation of labor income in generating

tax revenue, the establishment of longer working livesthrough a higher statutory retirement age would help stabilizethe government budgets. The mandatory public pensioninsurance, however, can be relieved through later retirementonly if the additional contributions paid are not fullycompensated by entitlement to higher pensions. Thepension formula therefore has to be adjusted accordingly,which implies that the pension level is lowered indirectly.Such a policy change might create negative work incentives,but the impact of these can be limited by making all laborearnings subject to insurance contributions.

In Germany, the social coverage of health risks is not onlythreatened by future spending increases due to demographicchange. Restricted competition among public healthinsurance companies as well as lack of control and asymmetricinformation create additional cost pressure. Substantialorganizational changes are necessary to control the fast-risingburden that is put on labor by health and long-term care.

Most importantly, competition should be openedbetween the numerous providers of health and long-termcare insurance. This requires that the system of mandatorypublic health insurance, which only covers employees whoare below a certain income threshold, is extended to allemployees. At present, high-income workers who havesystematically lower health risks are allowed to buy healthinsurance from private providers, which prevents from anefficient allocation of risk between the public and private

Raising the Legal Retirement Age

insurers. After the establishment of mandatory universalcoverage the hitherto public providers of health and long-term care insurance should be privatized.

To make competition work, it is furthermore necessarythat insurance companies be allowed to provide differentservice packages, in contrast to the current system of basicallyuniform services of public health insurers stipulated by thegovernment. In a fully privatized market for health insurance,the government’s only tasks should be to guarantee the freemobility of customers between insurance providers, and todefine a mandatory minimum coverage for health risks,which must be offered by any insurance company to anyapplicant (if of course not at uniform cost). Beyond thisminimum coverage, individuals could choose to buy addi-tional insurance benefits according to their individualpreferences.

Immigration raises the potential economic performance ofa country. The incumbent population especially benefits fromimmigration if immigrants fill labor shortages and integrateeasily into the labor market. Given the magnitude of thelooming demographic disruptions, immigration cannot bea substitute for labor market reforms and effort at fiscalconsolidation. As a very flexible complement to domesticreforms, however, immigration is a powerful tool foreconomic policymakers.

In order to take full advantage of the positive effectsfrom immigration, Germany should start selecting labormigrants systematically. Temporary migration of workers

who fill short-term shortages should be regulated throughan auction system. Permanent immigration, on the otherhand, should be controlled by means of a point system as itis envisioned by the recently enacted immigration law. Todesign the point system according to the needs of theGerman labor market, a trial phase with small immigrationquotas should begin immediately. This is essential to havean efficient point system ready when, due to demographicchange, the demand for immigration will rise sharply at theend of the decade. Of course, the trial phase should beevaluated scientifically, in order to identify those immigrantswho have the best labor market prospects.


“On a trip to the Land of Cockaigne, a group of frogs jumped into a pail of milk and indulged them-selves. Few of them noticed at first that they would not be able to get out easily because the wallswere too slippery. One frog just barely managed to get out and began to wail loudly. The others,however, continued their self-indulgence without a care in the world. As the milk level dropped fur-ther, the walls became unclimbable. Suddenly, the frogs all started thrashing about and doingeverything to stay afloat. After a while, some gave up and drowned. The others kept on strugglinguntil they felt chunks of butter forming underneath their feet, which gave them a false sense of se-curity. Only one of the frogs eventually summoned the courage to take a forceful leap to safety.”

This fable has a lot in common with the problems of the German labor market. In the 1960s, labormarket problems seemed solved. Full employment was defined as an unemployment rate of closeto zero. Economic growth – at an impressive average of four percent – guaranteed a high standardof living and encouraged the creation of a comprehensive social welfare system on the basis of seem-ingly secure growth prospects. Early warnings that this was merely a fair-weather system were ig-nored. Even as global crises and impending demographic changes caused the first disruptions ofthe system in the 1980s, nothing was done to change course. Distracted by the subsequent posi-tive trend in global economic development, and later by German reunification, labor market poli-cy has been dominated by social policy objectives throughout the past two decades. The “Christ-ian socialism” of the Kohl era continued to shape national policy during Schröder’s first term.Under the Schröder administration, the fall turned into a nosedive, which resulted in the shatteredreputation of the Federal Employment Services (Bundesanstalt für Arbeit) in Nuremberg.

In this kind of situation, marginal changes in labor market policy are useless. The only way out ofthe current dilemma is a complete reorganization of labor market policy and the social security system. This can only be done, however, if the gov-ernment initiates the necessary steps during the first year of the administration’s four-year term. The closer election day comes, the smaller thechance of achieving reforms, because voters tend to punish governments for painful reform measures even before the programs begin to producebenefits. As the time window is about to be closed again, our policymakers must take swift action. Against this background, IZA has designed anaction program for improving the economic framework to increase employment.

The new administration has once again declared unemployment as the main focus of government activity. Although several details of Schröder’snew course of action may be flawed, at least he has summoned the courage to initiate the right steps. These include combining the political re-sponsibility for economics and labor in one ministry, improving macroeconomic conditions through a reinterpretation of the European Stabilityand Growth Pact, encouraging female labor market participation by the establishment of all-day schools, and implementing key proposals of theHartz Commission. The planned merging of unemployment aid and social assistance will lead to a reduction of transfer payments to the unem-ployed. This is a painful but inevitable first step out of the crisis.

The labor market problem can only be solved, however, with a consistent long-term approach to combat the causes of unemployment. This in-cludes the development of the low-wage sector and the deregulation of health services as well as child care and long-term care for the elderly. Wemust provide more work incentives by turning away from the single wage-earner model and abolishing the subsidization of early retirement. Thereorganization of unemployment insurance according to market-based criteria must go even further than proposed by the Hartz Commission. Ac-tive labor market policy, which needs to be subjected to thorough scientific evaluation, should focus exclusively on an effective reintegration of theunemployed into the labor market. The responsibility of the collective bargaining parties for unemployment must become more institutionalized,and agreements within individual companies should receive a larger weight. The lack of labor market flexibility has become a symbol of Germany’sinability to undertake reforms. To achieve more flexibility, a legally governed system of severance pay should replace our rigid system of layoff pro-tection. Furthermore, we should encourage competition among our educational facilities, improve the efforts to reform our pension system, raisethe retirement age, and allow more immigration to prepare our country for the demographic changes ahead.

IZA’s “Seven Proposals for Modern Active Labor Market Policy” are meant to stimulate our poli-cymakers to take decisive action – not only in the interest of the unemployed, but also for the sakeof Germany’s future as a business center.

O P I N I O NThe German Labor Market – Bound for Consistent Reform?

Institute forthe Studyof Labor

IMPRESSUMEditor: Prof. Dr. Klaus F. ZimmermannManaging Editor: Holger HinteIZA, P.O. Box 7240, 53072 Bonn, GermanyTel. +49 (228) 38 94 222, Fax +49 (228) 38 94 180e-mail: [email protected]/Photographs: IZALayout/Printing: Verlag Erik Dynowski, Cologne, Germany

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