Europe's largest economy under pressure, German officials warn that the Iran crisis may halve economic growth in 2026.

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The German economy is facing a severe threat from the escalation of the Middle East situation.

On March 26, according to Bloomberg citing informed sources, German officials believe that if the Iran conflict continues, Germany's economic growth in 2026 may be only half of the official target. This situation will not only aggravate the difficulty of fiscal consolidation for the German government, but also force a reassessment of overall growth prospects for the eurozone.

According to informed sources, internal calculations by the German government show that in the worst case scenario, that is, if the Middle East crisis continues to spread, Germany's GDP growth in 2026 may fall to 0.5%, far below the previous prediction of 1%. If energy prices remain at their current high levels for just a few weeks, growth is expected to fall in the range of 0.6% to 0.7%. In the worst case, growth in 2027 will also be 0.1 percentage points lower than expected, dropping to 1.2%.

Relevant risks have already led the European Central Bank and the Italian government to lower their growth forecasts. According to Bloomberg, the Italian government plans to lower the country's 2026 growth projection to 0.5%. The German Bundesbank also lowered its economic expectations on Thursday and listed the Iran conflict as a major factor that could cause the German economy to stagnate in the first quarter.

Shadows Cast Over Hopes of Recovery

For the coalition government led by German Chancellor Friedrich Merz, the escalation of the Middle East conflict is a significant setback. Previously, after two years of contraction and near stagnation, the German economy had shown signs of recovery driven by public investment, and the government was hoping for a lasting rebound.

Currently, the energy supply disruptions triggered by the Middle East conflict are posing an increasingly severe blow to Europe's largest economy. Germany's official economic forecast will be jointly released by several major economic research institutes on April 1; the internal scenario analysis mentioned above may not necessarily be directly reflected in it.

Fiscal Pressure Intensifies, Tax Increase Discussions Emerge

The slowdown in economic growth poses a particularly severe challenge to Germany's public finances—weak growth means a corresponding reduction in tax revenues.

At present, the CDU/CSU led by Chancellor Merz is holding negotiations with the center-left Social Democratic Party on large-scale reforms, aiming to restore economic competitiveness and fill a fiscal gap of up to 140 billion euros (about 162 billion U.S. dollars) before the current legislative term ends in 2029.

Although the government has launched an infrastructure investment plan of about 500 billion euros and lifted the "debt brake" for defense spending, next year's core budget still needs to be cut by 20 billion euros, and the cuts will rise to 60 billion euros in 2028.

According to Bloomberg citing informed sources, given that spending cuts alone are unlikely to close the gap, officials have started discussing the possibility of raising the VAT rate from 19% to at least 21%. This move, following the easing of the “debt brake” rule for infrastructure spending, would cross another red line for conservative voters—Merz had previously pledged not to raise taxes, and such measures are not included in the coalition agreement.

Energy Subsidies and Intra-Party Division

Meanwhile, the coalition government is weighing whether to introduce further support measures to ease the burden on consumers from soaring fuel prices. Finance Minister Lars Klingbeil has proposed a windfall tax on energy companies to avoid further pressure on the budget, but the plan has been opposed by Economics Minister Katherina Reiche of the CDU.

Politically, far-right forces are continuing to expand their influence by harnessing public dissatisfaction with the economic slump. The nationalist Alternative for Germany (AfD) party’s support now rivals that of Merz’s conservative bloc. Regional elections later this year in eastern German states may allow the AfD to take power in a federal state for the first time.

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