Europe's Largest Economy Under Pressure; German Officials Warn Iran Crisis Could Halve 2026 Economic Growth Rate

Germany's economy is facing a severe threat from the escalation of the situation in the Middle East. On March 26, according to Bloomberg citing people familiar with the matter, German officials believe that if the conflict with Iran continues, Germany's economic growth rate in 2026 may be only half of the official target. This situation not only exacerbates the difficulty of the German government's fiscal consolidation but also forces a reassessment of the overall growth prospects for the Eurozone. According to sources, internal calculations by the German government indicate that in the worst-case scenario, where the Middle East crisis continues to spread, Germany's Gross Domestic Product (GDP) growth rate in 2026 could fall to 0.5%, far below the previously predicted level of 1%. If energy prices merely remain at current high levels for several weeks, growth is expected to fall within the 0.6% to 0.7% range. In the worst-case scenario, the growth rate in 2027 would also be 0.1 percentage points lower than expected, dropping to 1.2%. Related risks have already prompted the European Central Bank and the Italian government to successively lower their growth forecasts. According to Bloomberg, the Italian government plans to lower its 2026 growth forecast for the country to 0.5%. The Deutsche Bundesbank also lowered its economic forecast on Thursday, citing the Iran conflict as a significant factor that could lead to a possible stagnation of the German economy in the first quarter. Recovery Prospects Clouded For the ruling coalition led by Chancellor Friedrich Merz, the escalation of the Middle East conflict represents a clear setback. Previously, after experiencing two years of contraction and near-stagnation, the German economy had shown signs of a rebound driven by public investment, and the government was pinning its hopes on a sustained recovery. Currently, energy supply disruptions triggered by the Middle East conflict are posing an increasingly severe shock to Europe's largest economy. Official German economic forecasts will be jointly released on April 1 by several major economic research institutions, and the aforementioned internal scenario calculations may not be directly reflected in them. Fiscal Pressure Mounts, Tax Hike Discussions Surface The economic growth slowdown poses a particularly severe challenge to Germany's public finances—sluggish growth means a corresponding reduction in tax revenue. Currently, the CDU/CSU, led by Chancellor Merz, is negotiating large-scale reforms with the center-left Social Democratic Party, with the goal of restoring economic competitiveness and filling a fiscal gap of up to 140 billion euros (approximately 162 billion US dollars) by the end of the current legislative period in 2029. Despite the government's introduction of an infrastructure investment plan worth approximately 500 billion euros and the exemption of defense spending from the "debt brake" restrictions, the core budget still needs to be cut by 20 billion euros next year, with the scale of cuts reaching 60 billion euros in 2028. According to Bloomberg citing people familiar with the matter, given that spending cuts alone are insufficient to bridge the gap, officials have begun discussing the possibility of raising the value-added tax rate from 19% to at least 21%. This move would be another policy touching the bottom line for conservative voters, following the relaxation of the "debt brake" rules for infrastructure spending—Merz had previously explicitly promised no tax increases, and there is no such arrangement in the coalition agreement. Energy Subsidies and Party Divisions At the same time, the coalition government is weighing whether to introduce further support measures to alleviate the pressure consumers are facing due to high fuel prices. Finance Minister Lars Klingbeil has proposed a windfall tax on energy companies to avoid further pressure on the budget, but this proposal has been opposed by the CDU Economics Minister Katherina Reiche. Politically, far-right forces are continuing to expand by exploiting public dissatisfaction with the economic downturn. The nationalist party Alternative for Germany (AfD) has seen its support ratings move neck-and-neck with the conservative bloc led by Merz. State elections in eastern Germany later this year could see the party take power in a federal state for the first time.