Germany is taking a historic step to alleviate the shortage of workers: allowing retirees to continue working

The plan to give working retirees €2,000 tax-free is, in essence, a pragmatic and technocratic response to a demographic shock.

In September 2023, Europe turned in unison towards Germany. What was normally one of the strongest economies in the eurozone was sounding the alarm: increased life expectancy combined with an inverted demographic pyramid and an inflationary environment painted a very bleak picture for those about to retire. In fact, the system was forcing pensioners to look for work to supplement their pensions.

Two years later, things have not improved, so the government has normalised them.

A structural shift.

Friedrich Merz’s government has put forward a clear and pragmatic proposal: to allow retirees who decide to continue working to earn up to €2,000 per month tax-free, a measure (the so-called ‘active pension plan’) designed to tackle the growing labour shortage that is gripping Europe’s largest economy.

The initiative is part of the package of reforms that the executive has sold as its ‘autumn of reforms’ and, according to the draft legislation in the hands of the Financial Times, will come into force on 1 January. The coalition with the Social Democrats is set to approve it on the grounds of retaining experience and knowledge in companies and raising the employment rate in a country facing one of the most severe demographic transitions on the continent.

What is being offered and what is being retained.

The measure exempts up to €2,000 per month of additional employment income for retired people from tax, but does not eliminate contributions: employees and employers will continue to pay social security contributions on these salaries, which (according to the government) will help to strengthen healthcare and pension finances while improving the liquidity of companies with senior experience.

The existing advantages for those who opt for early retirement are not being abolished (the legal age remains 67, with incentives to retire at 63). Rather, the change aims to offer a tax incentive for those who are able and willing to extend their working life to do so.

Public cost and projections.

The government itself estimates that the loss of tax revenue due to this incentive will cost around €890 million per year from the time it comes into effect, a figure that some institutes consider optimistic: the IW Institute calculates an annual cost closer to €1.4 billion and puts the potential number of beneficiaries at around 340,000.

Economists such as Holger Schmieding warn, however, that the net impact could become positive in two or three years if the increase in economic activity and contributions offsets the initial tax loss, in addition to the possible ‘psychological effect’ of socially valuing the contribution of older people.

International lessons.

The government is looking, among other examples, to Greece: when Athens allowed pensioners to keep their full pension and pay an additional reduced rate (10%) on their earned income, the number of retired workers rose from 35,000 in 2023 to more than 250,000 in September of the following year, a jump that illustrates the power of tax incentives to mobilise labour supply among older groups.

This experience is used in Berlin as a sign that the policy can work, even though the scale, labour structures and employment cultures differ.

Consequences for the labour market.

The move aims to tackle several structural symptoms: Germany currently has some of the shortest average working hours in the OECD and a marked increase in part-time work (which now accounts for 30% of the workforce, more than double the figure at the beginning of the 1990s). The policy aims both to increase effective hours and to retain human capital that would otherwise be lost to companies.

Retaining senior staff can help reduce bottlenecks in sectors with a shortage of skilled workers and facilitate the transfer of know-how, but it also poses the challenge of adapting jobs, ergonomics and internal policies to an ageing workforce.

Political and economic risks.

The main risk is twofold: on the one hand, the measure may penalise young people and employees in the early stages of their careers if companies choose to retain positions with cheaper payrolls and more experienced workers.

On the other hand, the government’s fiscal estimate could fall short if uptake is high, putting pressure on public accounts at a time when the cost of social systems is already straining the budget. In addition, The Times pointed out that there is an equity and public narrative dimension: encouraging people to work longer is politically sensitive when there are sectors with precarious employment or stagnant wages.

Pragmatism with doubts.

In short, the plan to allow €2,000 tax-free for working pensioners is, in essence, a pragmatic and technocratic response to a demographic shock and a lack of skilled labour: it seeks to monetise experience, sustain contributions and gain economic muscle without resorting solely to mass immigration or abrupt increases in working hours.

However, its success will depend on the extent of uptake, how it is combined with other labour policies (training, work-life balance, redistribution of part-time work) and the accuracy of fiscal projections: if uptake is high, the cost could approach the most pessimistic figures, and if it is moderate, the initiative could become a respectable exercise in institutional adjustment that contributes to extending the working life of many and partially mitigating the cost of ageing. This is an unknown scenario that Japan is also considering.