In the run-up to Germany's upcoming snap election on Feb. 23, 2025, some policymakers have been debating a loosening of the country's "debt brake" rule.

Under this rule, Germany's 16 regional states must, in principle, maintain fully balanced budgets, while the federal government's permissible annual structural deficit is limited to 0.35% of GDP. Higher deficits are, however, allowed in a cyclical downturn, or in the event of a natural catastrophe or similar crisis.

The rule limits Germany's fiscal policy space and is said to have contributed to the collapse of the country's national government in late 2024.

In this Credit FAQ, S&P Global Ratings looks at the role of the debt brake in its assessment of the federal states, Germany's regional tier of government. We also explore what impact a modification of the rule could have on ratings.

Frequently Asked Questions

How could Germany increase fiscal space under the debt brake rule?

The most straightforward way to loosen the deficit limitations would be to temporarily suspend the debt brake by invoking the constitutionally foreseen exemption for natural catastrophes and similar events. Only a simple majority in the federal or--in case the suspension is to apply only to the respective regional budget--a single-state parliament is required to achieve this. That said, such a suspension carries a legal risk. The federal or a state constitutional court could reject it on the grounds that the proposed deficit spending is disproportionate to the crisis it claims to respond to, and hence breaches constitutional law. This is essentially what happened in 2023, when Germany's federal constitutional court ruled against the repurposing of €60 billion in unused pandemic-related borrowing to finance Germany's green transition because the repurposing was seen to be at odds with the debt brake rule (see "Germany's Medium-Term Growth Could Suffer From Top Court's Decision," published Nov. 27, 2023).

A second avenue for creating additional fiscal flexibility could be to carve out a specific expenditure envelope from an otherwise unchanged debt brake. A two-thirds majority in both houses of the federal parliament would have to support such a move, but, in our view, a constitution-amending vote like this carries little risk of judicial review. Germany's €100 billion spending authorization for military equipment purchases following Russia's invasion of Ukraine in February 2022 has set a precedent here. In our view, the next German government might attain the required political majorities more easily if it proposes to carve out a limited and clearly delineated spending envelope for a broadly supported purpose, for example, transportation infrastructure, digitalization, energy supply, economic stimulus, or another defense package. We think that an appropriately worded carve-out could extend to state spending, allowing interested states to locally authorize and implement qualifying projects.

A third option would be to structurally change the debt brake legislation itself, for example, to grant states a generally permissible annual deficit. This would also require an amendment of the federal constitution, and it therefore also needs two-third majorities in both chambers of the federal parliament. Following an adjustment of the debt brake in federal legislation, Germany's states would then be free to modify their own rules. However, given that the Bundesrat, Germany's second chamber of parliament, reflects the diverse multi-party coalitions that govern the different regional states, the broad political consensus necessary for such a fundamental and permanent modification could, in our view, be more difficult to achieve than for a more limited carve-out.

Would a revision of the debt brake rule at the federal level automatically loosen the states' deficit limit?

No, there would be no automatic loosening and no requirement for the states to change their own legislation. Each state can decide for itself whether to loosen its fiscal rules, as long as these remain stricter than the federal constitutional framework requires.

That said, relaxing the debt brake at the federal level would very likely have a signaling effect, making it easier politically for regional states to follow suit. However, more fiscally conservative states might decide to retain their own rules that are more restrictive than a looser federal framework.

How does S&P Global Ratings reflect the debt brake in its ratings on German states?

Our ratings on German states are based on the quantitative and qualitative factors specified in our criteria, "Methodology For Rating Local And Regional Governments Outside Of The U.S.," published July 15, 2019. These factors include, among others, budgetary performance and debt levels.

Our assessments reflect the thresholds for the deficit and debt ratios outlined in the criteria, which are not aligned with the limits that the debt brake sets. We do not distinguish whether observed deficit and debt ratios result from fiscal policy decisions that the states have taken to comply with an externally imposed rule, or whether they are, for example, the consequence of the prevailing macroeconomic environment. In our view, a fiscal rule like the German debt brake, whether self-imposed by a state or set by a higher level of government, can support fiscal efforts, but it is neither necessary nor sufficient for a state to achieve the fiscal performance that supports a specific rating.

Compliance with a debt brake rule can, however, influence our view of a state's financial management and the institutional framework that German states operate under. A credible rule can contribute to the fiscal system's predictability and transparency, which are components of our institutional framework assessment. For example, we believe that the debt brake contributes to the balance of power between state finance ministries and other government departments when they are negotiating budgets. Under the rule, supporters of higher spending need to spend significantly more political capital to gain additional flexibility. Abiding by fiscal targets usually supports our view of managerial capacity. Conversely, when targets are missed or circumvented, for example, by using off-budget spending or accounting practices aimed at exploiting loopholes in the rule, this could indicate lax managerial standards or limited political strength.

What could the rating impact be of relaxing the deficit limit for German states?

The impact of a looser fiscal rule would primarily depend on a state's fiscal policy decisions. If additional spending under a more flexible rule leads to higher deficits, this could affect our assessment of a state's budgetary performance relatively quickly. In contrast, we consider that it would take some time for successive deficits to accumulate to such an extent that the higher debt stock itself would put pressure on our ratings on German states.

We ran a scenario analysis to simulate what affect a relaxation of the debt brake rule could have. Thereby, we assumed that the states could incur a deficit of 0.35% of GDP, instead of having to fully balance their budgets. This would align the rule for states with the deficit that Germany's central government can incur currently. We note that several policymakers have proposed this in the country's pre-election debate:

Our simulation illustrates the effect an increase in annual expenditure by the assumed 0.35%-of-GDP deficit allowance would have on the S&P Global Ratings-rated German states' five-year average balance after capital accounts, one of our key budgetary performance indicators. We used our current predictions for the states as the starting point for this simulation. Under our scenario, the states in question would incur low- to mid-single-digit deficits after capital spending, measured as a percentage of their adjusted total revenue. Compared against the thresholds that guide our analysis, such incremental deficits could put pressure on our assessment of budgetary performance (see chart 1). That said, even if the fiscal rules were loosened, the states could, of course, still decide to voluntarily pursue more conservative fiscal policies.

Chart 1

Our scenario analysis furthermore suggests that an incremental annual deficit of 0.35% of GDP under a looser fiscal rule could, over a five-year period, translate into additional debt of between 12% and 20% of states' consolidated operating revenue. This assumes that new borrowing will fund all deficits in full.

When we add such incremental borrowing to our current projections for each rated state's 2026 debt burden, we find that most states would likely be resilient to such a debt increase. This means that there would only be limited near-term rating pressure from the higher stock of debt (see chart 2). However, sustained debt accumulation could put more pressure on our debt assessments in the medium-to-long term.

Chart 2

It is hard to say at this point whether a 0.35%-of-GDP deficit allowance for states would affect our assessment of their institutional framework, financial management, and liquidity position, as this requires a holistic assessment. It would likely depend on other developments affecting these rating factors at the same time, and on how individual states react to the increase in fiscal latitude. The risk of higher deficits intersecting with other negative trends would naturally be higher for states that don't have a stable outlook.

Finally, our analysis doesn't capture the potential cost of inaction. Specifically, we don't consider whether the current fiscal rule prevents necessary investments, possibly causing us to eventually reflect underspending in our ratings.

What comes next?

We believe that Germany's debt brake rule will, at least in principle, remain in place after the upcoming national election. However, we consider it conceivable that a limited relaxation could eventually be enacted. This could comprise a small deficit allowance for the state level, or a carve-out of noncontentious spending items through federal legislation.

In our view, Germany's Christian Democratic Union (CDU)--which is widely expected to become the strongest party in the next parliament--holds the key to any reform of the debt brake. We understand that political support for modification is stronger at the state level. Even conservative-led governments such as in Berlin or Schleswig-Holstein are reported to support a relaxation of the fiscal rules due to their tight and less flexible budgets.

At the national level, we can rank the political parties running for the upcoming election by their stated support for modifying the debt break rule (see chart 3). Based on the most recent polls, we believe that the CDU could be the pivotal element in any reform. Although its election manifesto calls for maintaining the debt brake, recent statements by Mr. Merz–-the CDU's leader and the country's likely next chancellor–-have been interpreted as a signal that he could consider limited modifications to the rule, for example in post-election coalition negotiations.

Chart 3

Related Criteria

• Methodology For Rating Local And Regional Governments Outside Of The U.S., July 15, 2019

Related Research

• Local And Regional Government Outlook 2025: Weak German Growth Will Require New Borrowing, Jan. 16, 2025
• Germany's Medium-Term Growth Could Suffer From Top Court's Decision, Nov. 27, 2023
• Institutional Framework Assessment: New Challenges Could Test German States' Commitment To Balanced Budget Rules, May 25, 2023