Germany is struggling to rein in rising social welfare levies that are driving up the cost of labour, but the centre-left government seems unable to stomach the painful reforms needed to encourage job creation.

As Europe's largest economy has ground to a halt in the last year and joblessness has soared above four million, payments to health, pension and unemployment insurance schemes for those still in work have risen, in turn discouraging new hiring.

The problem will only worsen as Germany's population ages rapidly in the coming decade, driving up pension and health costs while reducing the number of workers to pay for them.

Economists say radical reforms are needed now to break out of this vicious circle, including big cuts to welfare spending and more private provision of services, but they doubt the Social Democrat-led government has the will to enact them.

Chancellor Gerhard Schroeder, who narrowly won a September election despite the sluggish economy, says he recognises the urgency of health and pension reforms, but his first priority is overhauling Germany's notoriously inflexible labour market.

With Schroeder's traditional trade union allies already gearing up for a fight over those plans, analysts suggest he will avoid simultaneous health and pension cuts, especially before two regional elections in February.

"The measures considered by the ruling coalition are not suited to producing short-term cuts in spending. Increasing labour costs will prompt firms to delay or avoid creating jobs," said Jochen Pimpertz of the Institute for German Economics (IW).

"West German labour costs are already the highest in Europe. The signal the government is sending out goes in the wrong direction and could create an upward cost spiral."

The government wants to cut the combined cost of compulsory pension, health, unemployment and disability insurance fees to under 40 per cent of gross wages - payments which are split equally between workers and their employers. But the figure is currently at 40.4 per cent of gross wages and rising fast.

With Germany's budget deficit already on course to break the European Union's limit of three per cent of gross domestic product this year, the government is desperate to find stop-gap measures to control welfare costs and raise new revenue.

The most pressing problem is exploding health costs. Germans pay more for health care than any other nation apart from the United States and Switzerland. Health Minister Ulla Schmidt has warned that health contributions could rise from 14 to 15 per cent of gross wages next year without big savings.

She has proposed a package of cuts, including caps on drug spending and a pay freeze for doctors, worth e4 billion to come into effect on January 1.

But analysts say health costs will continue to soar unless Schroeder limits the treatments those insured get for free and increases the amount patients pay towards the cost of treatment, both moves that Minister Schmidt has ruled out.

"Over 17 per cent of expenditure could be cut by limiting the catalogue of treatments available," said IW's Pimpertz. "Patients must also make bigger excess payments towards costs to promote patient responsibility."

Despite tax breaks that came into effect this year to encourage Germans to take out private pensions as state benefits fall, retirement costs are still out of control.

Government sources admitted on Wednesday that pension contributions would probably rise to 19.5 per cent of gross wages next year from 19.1 per cent at present. The government plans to raid pension reserves and increase the proportion of wages on which contributions are paid to try to plug a gaping deficit.

Pimpertz again: "The official pension age is 65 but in fact the average retirement age is 60.5. That gap must be closed and that will automatically erase the deficit. In the medium term, the state pension must be further reduced."

But Schroeder looks unlikely to swallow the bitter pill prescribed by economists, proposing instead forums to discuss health and pensions based on the example of the Hartz Commission that brought government, business and union representatives together earlier this year to debate labour market reforms.

Economists, opposition politicians and commentators have slammed the idea as a delaying tactic that is unlikely to produce many new ideas or a mandate for radical action.

"Commissions of experts will not come up with anything that has not already been proposed," said Ralph Solveen, an economist at Commerzbank.

"The government has stressed the importance of solidarity, which is to say they want to maintain the current welfare system and not increase private provision or the paying of excesses, which means contributions will continue to climb," he said.