Tax Policy Options for a United Germany
Author:
International Monetary Fund
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Publication Date:
01 Jan 1990
eISBN:
9781451952216
Language:
English
Keywords:
WP; tax system; income tax; net profit; double taxation; indirect tax; wage tax; FRG tax system; tax schedule; reform scenario; taxable income
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A central requirement in the rapid movement of German Democratic Republic (GDR) toward a market economy is the introduction of a market-oriented tax system. The paper highlights the main features of the traditional socialist tax structure of the GDR and the current tax structure of the Federal Republic of Germany (FRG). Arguments for an adequate short-term tax reform in the GDR are developed in two scenarios, contrasting the approach of taking over the FRG tax system (adoption scenario) and an autonomous tax reform in the GDR (reform scenario). Both scenarios recommend a flexible adjustment approach which anticipates the medium-term development of the German tax system pursuant to domestic reform requirements, international tax harmonization and fiscal federalism.

Abstract

A central requirement in the rapid movement of German Democratic Republic (GDR) toward a market economy is the introduction of a market-oriented tax system. The paper highlights the main features of the traditional socialist tax structure of the GDR and the current tax structure of the Federal Republic of Germany (FRG). Arguments for an adequate short-term tax reform in the GDR are developed in two scenarios, contrasting the approach of taking over the FRG tax system (adoption scenario) and an autonomous tax reform in the GDR (reform scenario). Both scenarios recommend a flexible adjustment approach which anticipates the medium-term development of the German tax system pursuant to domestic reform requirements, international tax harmonization and fiscal federalism.

I. Introduction

The first free election in the German Democratic Republic (GDR), held on March 18, 1990, resulted in an overwhelming majority in favor of a change toward a Western market economy. The scenario of adopting the Federal Republic of Germany’s (FRG) successful system of a “social market economy”, designed in the post-war period by the Freiburg School of Economics (Eucken, Mueller-Armack et al.) and implemented by coalition governments under Christian-Democratic chancellors and ministers of commerce and trade, appears to have been the decisive element for the clear and unexpected victory of the conservative alliance in the election. The support of the Christian Democrats by the GDR population has evidently been reinforced by the pledge of their Western sister party and Chancellor Helmut Kohl to establish a monetary union within half a year, to introduce the deutsche mark (DM) and to guarantee an exchange rate at par for GDR savers, well before the process of political unification becomes effective. 1/

GDR agreement on the monetary union will shift the responsibility for monetary policy to the Bundesbank by July 2, 1990, according to the time schedule proposed in recent negotiations. But this important step toward a market economy has to be complemented by a major reconstruction of the GDR’s constitutional, legal, and institutional setting to provide conditions in which markets can exert their allocative superiority. One crucial step in this direction is to eliminate socialist central planning and price administration and to reduce governmental interference to the essential functions in market economies to correct market failures and to avoid an inequitable distribution of net household welfare.

One urgent requirement in this reconstruction process is to abandon the socialist fiscal system, which is based on the free access of the central government to any socialized property and its returns, and to replace it by an adequate market-oriented revenue system. At the same time, a democratically legalized budget process must be introduced, to collect the necessary amount of government revenues and to allocate public expenditures efficiently without distorting the market process.

In view of the medium-term target of a complete political unification of the two Germanys into one state, one is tempted to recommend the immediate adoption of the FRG’s present tax system for the GDR. Evidently, such a procedure has certain advantages: no time will be lost, no further change of the tax system will be necessary if unification proceeds, and there is no risk of keeping socialist elements in a newly designed tax system. On the other hand, one must question whether the FRG tax system, which reflects allocative and distributive targets of the highly developed FRG economy, could prove useful for the retarded GDR economy in its first steps toward market experience. It is argued that a takeover of FRG tax rules would result in low fiscal revenues and that transitional costs due to allocative distortions and administrative difficulties would be high. To mitigate these problems, the adoption of the FRG tax system could be only a partial solution.

In face of major deviations from the FRG tax system, which must be recommended if one takes into account the economic and administrative constraints given, another scenario for restructuring the GDR tax system is discussed in this paper. The scenario begins with the current general GDR tax code, which still contains basic elements of the common German tax system reestablished immediately after World War II. If present exemptions of socialized entities and confiscatory tax schedules are abolished, these GDR tax laws may form another suitable starting point for a short-term reconstruction of the GDR tax system. The reduction of income and wealth tax rates by the tax reform bill of March 1990 may be regarded as a first step. Further revisions and amendments may not only recognize trade-offs between conflicting economic goals due to social preferences of GDR citizens, they also offer the FRG the opportunity to anticipate medium-term tax reform targets. The prevailing FRG tax system has been under attack by academic economists as well as economic experts of various interest groups before, during, and after the implementation of the last major tax reform, which was finalized only this year. All political parties have revealed their readiness to consider further steps of tax reform concentrating on business taxation and internal market requirements. Moreover, given the arduous transition process the GDR will have to undergo, it may veil pay to consider from the beginning anticipated changes in the FRG tax system, to escape the social costs of readjusting the new GDR tax system soon thereafter.

This paper is organized as follows. Chapter II highlights the main features the traditional socialist tax structure in the GDR and the current tax structure in the FRG. (A summary of the GDR tax system is provided in the Annex.) The following two chapters develop arguments for an adequate tax reform in the GDR in two scenarios, contrasting the economic consequences of a takeover of the present FRG tax system (adoption scenario, Chapter III) and an autonomous GDR tax reform (reform scenario, Chapter IV). Chapter V focuses on three major medium-term issues: domestic tax reform, international tax harmonization, and fiscal federalism, which will induce a deviation of the tax system in a united Germany from the current one in the FRG. The main conclusion of this paper, given in Chapter VI, is that an economically adequate GDR tax system may be based on either short-term scenario, if transitional and medium-term tax policy targets are recognized in the tax proposal.

II. The Tax Systems of the GDR and the FRG

A look at the tax systems of the two Germanys shows the marked differences, due to the different sizes of government and the different functions of taxes in a centrally planned economy versus a market economy. Total government expenditures amount to more than three fourths of the gross national product in the GDR 2/, in contrast to levels around 47 percent in the FRG social market economy (Table 1). In the FRG, about one third of the total revenues collected derive from social insurance contributions and the taxes (net of social insurance contributions) as a percentage of GNP have dropped to about 23 percent. In the GDR social insurance contributions account for only one tenth of total tax revenues, and social insurance contributions as a percentage of GNP (5 percent) are well below the FRG’s quota (14 percent). The main source of government revenues in the GDR is the direct access of the central planning authority to the socialized production sector.

Table 1.

Public Sector Revenues and Expenditures for FRG and GDR

(In percent of GNP)

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Source: Statistisches Jahrbuch der DDR, Statistisches Jahrbuch der BRD, various volumes; Sachverstaendigenrat, 1989; OECD, 1989, Tax Revenues Statistics 1965-1988; Institute of International Finance; own calculation.

A a more detailed view of the tax revenue structure in the two countries can be seen by breaking down GDR taxes according to the GFS (Table 2). Taxes on goods and services bring in about one fourth of total tax revenues in both countries. Social security contributions raise less than 10 percent, about one forth that in the FRG. On the other hand, a payroll tax (labeled contribution to social funds) was introduced in the GDR by 1984. This tax is not earmarked for social expenditures, but it may be related to social insurance contributions as it uses the same tax base. Taxes on income and profits bring in one third of tax revenues in the FRG, mostly from wage taxation. In the GDR, more than half of total revenues stem from income and profit taxation, predominantly from taxing the profits of socialized enterprises.

Table 2.

Tax Revenues in FRG and GDR

(in billions of DM and M)

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Source: OECD, 1989; Statistisches Jahrbuch der DDR 1988, 1989; own calculation.

A breakdown of GDR taxes by taxable units shows the characteristic pattern of a centrally planned economy. Compulsory payments of socialized enterprises, which according to socialist terminology are not regarded as taxes and therefore labeled as levies or profit transfers, are the dominant fiscal source to the government and account for nearly 90 percent of total “taxes” (Table 3). Taxes on other economic entities (socialist cooperatives, private craftsmen, etc.) are of minor fiscal importance. This is also true for the wage tax, which accounts for only 5 percent of total tax revenues.

Table 3.

Tax Revenues in the GDR

(in billions of M)

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Source: Statistisches Jahrbuch der DDR, vol. 1988 and 1989.

Tax revenues (net of social insurance contributions) in the FRG follow the characteristic pattern of a developed market economy (Table 4). Personal income taxes (in 1988 42.9 percent) and a general sales tax (in 1988 25.3 percent) account for more than two thirds of total tax revenues. Another fifth of tax revenue is derived from corporate income tax, local business tax, and two major excises on tobacco and petrol. The remainder of the more than forty FRG taxes is of minor fiscal importance.

Table 4.

Tax Revenues in the FRG

(in billions of DM)

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Source: Statistisches Jahrbuch der BRD, various volumes; Finanzbericht, vol. 1989 and 1990; Sachverstaendigenrat, 1989.

1. The structure of the GDR’s tax system

The GDR’s tax system exhibits the characteristic complexity of a centrally planned economy. Socialized enterprises 3/ are subject to compulsory payments to the central budget according to a four-channel system. These payments are not determined by a legal rate schedule or binding regulations, but are fixed according to short-term targets in the central-planning process. The exemption of socialized enterprises from general tax laws is justified mainly by two arguments: (1) all profits of socialized enterprises belong to the state. Hence tax laws, which constitute a transfer of financial resources from the private to the public sector are not applicable; and (2) a flexible structure of payments is desired to achieve major socialist management goals, such as increasing efficiency, stabilizing production and profits, or improving work effort and creativity.

Special regulations apply to groups of privileged taxpayers, which are supposed to promote the goals of the socialist society. Cooperatives, private craftsmen, commission agents of socialized trade, and labor income earners are therefore exempted from “general” tax laws and are subject to special tax regulations fixed by various decrees and ministerial orders.

General tax laws, which still exist in the GDR, are applied to all taxpayers who have not been exempted. The general tax code comprises those tax laws, which were reintroduced in both parts of occupied Germany after World War II, particularly income tax, corporate income tax, turnover tax, net wealth tax, the business tax (Gewerbesteuer), and real estate tax. Basically, the structure of the traditional tax laws remained, although the application of these taxes has been eroded by explicit exemptions and confiscatory tax rates charging personal and corporate income, and private property. In contrast to developments in the FRG’s tax laws since 1949, the GDR’s tax laws do not exhibit the complexities of eroded tax bases for income and wealth taxes, the corporate tax is still of the classical (double taxation) type without integration, and the turnover tax law constitutes a traditional cascade-type sales tax.

a. Taxation of socialized enterprises

The four-channel system of taxing socialized enterprises consists of the production fund levy, the net profit transfer, the contribution for social funds and the product-related levies.

The production fund levy is a 6 percent tax on the net worth of real assets and thus might be interpreted as a rental for socialized capital goods used for production purposes. Nevertheless, the central authority is free to deviate from this rule; there are widespread concessions reducing the tax base as well as the tax rate and the effective levy may be well below the general 6 percent rate.

The net profit transfer is a lump-sum tax on enterprise profits, determined annually by the central planning authority. Tax reliefs which had been granted in case of profit shortfalls, were repealed in 1984. At the same time, the transfer to the central budget was raised to almost 100 percent for profits in excess of the plan target.

The contribution to social funds was introduced in 1984, representing a 70 percent tax on the payroll of socialized enterprises. The term chosen for the new tax is misleading, since revenues are not earmarked for any social purpose. Essentially, this new tax did not create new revenues for the central budget, as price administration prohibited any tax shifting, and the net profit transfer target had to be reduced accordingly by the plan authority.

Product-related levies are determined by price administration; an implicit unit tax rate is given by the difference between the producer price and the industrial sales price of consumer goods. These prices are fixed by the central price authority with respect to a variety of planning targets, and a proliferation of 3,000-4,000 tax rates is reported. Neither the number nor the amount of tax rates have ever been officially published, but retail price comparisons and government revenue figures offer some insights into the tax structure. The overall tax burden on consumer goods was between 35 percent and 40 percent in the 1980s, with an exceptional peak of 46 percent in 1984 (Table 11). The product-related taxes impose a heavy burden on most industrial consumer goods, semi-luxury food and tobacco, whereas necessities and most agricultural products appear to be tax exempt and heavily subsidized.

b. Taxation of cooperatives

Craftmen’s production cooperatives are taxed according to special regulations, which either correspond to levies on socialized enterprises (production fund levy, product-related taxes) or to taxes in the general tax code (income tax, turnover tax). The tax burden is generally lower than that of private enterprises. Most favorable tax rates are offered to cooperatives in the repair and service sector.

Agricultural cooperatives are taxed at different rates and schedules, according to their production activities and conditions.

c. Taxation of private business

Certain groups of private tradesmen, such as private craftsmen, private commission agents of socialized enterprises, and qualified freelancers, are entitled to preferential tax treatment. All other private business activities are taxed according to the general tax code. Turnover tax, business tax, income tax (and/or corporate income tax) and net wealth tax constitute a confiscatory tax burden, which has purged most private commercial activities. 4/ Whereas this has been in line with traditional targets of socialist societies, exemptions have nevertheless been offered to foreign enterprises. Tax authorities are entitled to apply lump-sum taxation on nonresidents, who are subject to limited tax liability, and also on immigrants for a certain period. For these taxpayers the tax load has become negotiable in advance, and there is some evidence 5/ that this administrative simplification has been used as a loophole to escape confiscatory taxation.

d. Taxation of labor income

Labor income has been exempted from general income tax since 1952 and taxed according to a less progressive tax schedule. The schedule on wages and salaries was changed only once since and shows a distinct hump-shaped form with top marginal rates up to 34 percent for low incomes and a top average rate of 20 percent for wage income exceeding M 15,000 per year (Table 5, Figure 1). Work-related expenses are deductible (a lump-sum allowance of M 1,200 is integrated in the base schedule), but no special expense allowances are granted. Public pension payments, social benefit payments, wage supplements for overtime and dangerous work are tax exempt. Premia, which are regularly paid to employees for successful economic performance, which means fulfillment of the plan target, are taxed at a reduced flat rate of 5 percent.

Table 5.

GDR Wage Tax Schedule (Basic Schedule G)

article image
Source: Decree on the Taxation of Labour Income (Oct. 15, 1953).
Figure 1:
Figure 1:

GDR wage tax (schedule G)

Marginal and average tax rates in %

Citation: IMF Working Papers 1990, 089; 10.5089/9781451952216.001.A001

Similar tax preferences are offered to members of cooperatives and to certain freelancers (artists, physicians, scientists, etc.).

2. Main features of the FRG tax system

The FRG tax system comprises more than forty single taxes, 6/ the most important of which are outlined below.

The personal income tax is levied in three forms; the wage tax and the capital yield tax are withholding taxes on wage income and on certain forms of capital income, the assessed income tax is levied on all other sources of personal income. Pursuant to the tax reform of 1990 marginal tax rates are rising from 19 to 53 percent (instead of 22 to 56 percent, but in a much less progressive way than before) and the average tax burden has also been considerably reduced (Table 6, Figure 2).

Table 6.

FRG Income tax schedule 1990

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Source: Finanzbericht 1989, own calculation.
Figure 2:
Figure 2:

FRG income tax schedule

Marginal and average tax rates 1990

Citation: IMF Working Papers 1990, 089; 10.5089/9781451952216.001.A001

Companies are subject to the corporate income tax with a tax rate of 50 percent on retained profits and a reduced rate of 36 percent on distributed profits. Corporate income tax has been fully integrated since 1977; taxes paid on dividends or other distributions are credited against personal income tax liabilities in the annual assessment.

A peculiarity of enterprise taxation in the FGR is the business tax, a second tax on enterprise profits, which is not levied on income from agricultural activities and self-employment. Due to its discriminatory effects, which create efficiency losses and horizontal inequities, the business tax has been attacked by industrial and craftmen’s interest groups for decades. However, campaigns for the abolition of the business tax have failed, since this tax is the only major autonomous source of tax revenues for local governments.

Property taxes are of minor fiscal importance. Nevertheless, there is an ongoing debate on allocative distortions of the net wealth tax through double taxation, since companies as well as individuals are liable to wealth taxation. Revenues from a second property tax, the real estate tax, accrue to local governments, who are also entitled to fix the tax rate.

Several taxes are levied on capital transfers, including the inheritance and gift tax, the real estate transfer tax, the bills of exchange tax and the capital transfer taxes on capital investment and on stock exchange turnover.

Sixty percent of indirect tax revenue derives from the value-added tax, an invoice based, multi-stage, net turnover tax on domestic consumption, which exempts exports as well as investment in business capital and equipment. Three major excise taxes are levied on mineral oil, tobacco, and alcohol. There are a series of minor excises on beer, coffee, tea, sugar, salt, sparkling wine, and electric lamps. Customs and import duties are levied, but funds are transferred directly to the EC budget (as well as 1.4 percent of revenues from the VAT). Two other taxes of fiscal importance are the motor vehicle and the insurance taxes.

III. The Adoption Scenario

Moving toward a market economy requires a fundamental renewal of the whole legal framework for economic activities in all centrally planned economies; the introduction of a general tax system is only one, but crucial, element. Given the arbitrariness and the anomalies of the existing GDR tax structure outlined above, as well as the confiscatory access of the State to income from economic activities, there is no doubt that the existing practice of levying taxes has to to be discarded and replaced by a market-oriented tax system. This must be done in accordance with the principles of a democratic market economy: legality, accountability, transparency, efficiency, and equity. With respect to the political target of a rapid and comprehensive unification of the two Germanys, an obvious short-term device is to replace the current GDR tax structure with the present FRG tax system.

There are at least four major advantages to this scenario:

(a) Taking over the existing FRG tax laws will save time, which otherwise would have to be invested in the elaboration and discussion of alternative tax reform proposals for the GDR.

(b) The adoption approach guarantees the introduction of a consistent and market-tested tax system, which has been revised only recently in the three-stage German tax reform of 1986/88/90. There is little risk that characteristic deformations of socialist tax structures will survive in GDR legislation.

(c) The FRG tax authorities’ experience in the administration and control of their tax system will help implement these taxes in the GDR and avoid costly adjustment processes.

(d) The political unification of the two Germanys in the near future will require a harmonised tax system. This step will be easy if there already exists a common tax system in both countries. Frictional costs of a second adjustment process in the GDR tax system can be avoided, if the FRG tax system is taken over immediately.

In view of these arguments, the adoption approach has been favored by politicians in both Germanys and by representatives of FRG industrial groups, 7/ and it has become the guideline for the fiscal policy program in the State Treaty, which was signed by the FRG and GDR Ministers of Finance on May 18, 1990. Nevertheless, major economic and political arguments can be raised against the adoption approach, which will be discussed in Chapter IV.

To analyze the economic consequences of the adoption approach, this chapter highlights the effects of implementing a one-to-one copy of the FRG tax system in the GDR. It is argued that this hypothetical one-to-one copy approach will generate three major problems: (1) a shortfall of GDR tax revenues and a shift toward indirect taxes; (2) a transfer of several undesirable tax proliferations into the “new” GDR tax system; and (3) an adoption of complex procedural rules, which seem dispensable.

A GDR tax system following present FRG tax rules will not allow a sufficient amount of tax revenue in the short run. Personal and corporate income taxes will contribute little to budget revenues, as taxable profits will be low in the transition period. Wage taxation, the main source of revenue in the FRG, will contribute little due to the high basic allowance, spouse splitting and tax preferences. Indirect taxes will not be able to close the revenue gap.

The GDR will inherit excise taxes, capital transfer taxes, the business tax and a tax on company net wealth, which have been widely criticized as inefficient and costly, and therefore might be abolished in a next step of the FRG tax reform.

The FRG tax system introduces highly complex rules aiming at economic efficiency, merit wants and distributional equity, which have been based on social preferences and political compromise in the past. The GDR will inherit these complexities, creating higher administrative costs compared to a less sophisticated and more transparent tax system.

Overcoming these difficulties requires an adjustment of the adoption scenario and a deviation from existing FRG tax regulations. Corporate tax adjustments aim at reducing allocative distortions and administration costs by simplifying depreciation rules, loss offsets for integrated enterprises, and taxation of distributed profits. Wage tax adjustments seem necessary to increase the tax base by temporarily suspending special expense allowances, reducing the basic allowance and switching from child allowances to direct transfers. In contrast to direct taxes, VAT and the three major excises on petrol, tobacco and alcohol should be adopted one-to-one without further adjustment. The introduction of these taxes appears to be most urgent to end the distortionary consequences of administered pricing and establish a reliable source of government revenues. FRG taxes, which are likely to be phased out in the internal market, should not be adopted.

1. The application of FRG tax laws to GDR companies

A one-to-one copy of FRG company taxation in the GDR will imply that GDR socialized enterprises, cooperatives, and newly founded companies will be subject to the corporate income tax, the business tax, and the net wealth tax. In contrast to the present distortional tax regime, the main economic impact will be a gain in allocational efficiency, but there will also arise the issue of administrative feasibility and fiscal sufficiency.

Basically, the three company taxes have also been part of the current general GDR tax system, but administrative experience is lacking since until now they have only been applied to a negligible share of economic activities. For socialized enterprises the corporate income tax, business tax and net wealth tax will replace the production fund levy and the net profit transfer. Introduction of these taxes will reduce the tax burden on the industrial sector, compared to confiscatory socialist profit taxation. Nevertheless, the FRG ranks at the top in an international comparison of statutory corporate tax rates (Table 7) and of effective company tax burdens as well 8/, although unfavorable corporate profits taxation on average is less a disadvantage in the FRG due to generous depreciation and valuation rules. Additional efficiency costs occur since effective tax burdens of FRG companies differ widely among sectors and sources of financing (Table 8).

Table 7.

Main Statutory Corporate Income Tax Rates 1990 1/

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Source: Tanzi and Bovenberg, 1990; Price Waterhouse; International Bureau of Fiscal Documentation.

Top bracket rates of federal corporate income tax on retained profits.

Table 8.

Effective Marginal Tax Rates for FRG Companies 1/

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Source: King and Fullerton, 1984, table 5.21; Leibfritz, 1987.

Calculations based on tax rules 1980, 1987 and 1990, normalized to fixed real gross rates of return (10%).

Different inflation rates: 0 percent (1980a), 4.2 percent (actual rate 1980), 10 percent (1980b).

By the introduction of the FRG Corporate Income Tax Law, GDR enterprises will be forced to establish a completely new, market-oriented accounting system and start with a reliable opening balance. It will also require a sound knowledge of the incentive structure of the FRG business tax system that does not provide a level playing field for investment and financial decisions. Since asset prices are lacking and the GDR management’s accounting experience is poor, a relatively generous transition to the new tax system will have to be allowed. As a consequence of this transitional tax relief and given the need for high investment to restructure, the deteriorated industry corporate income and business tax bases will be low or even negative in the transitional years.

In line with the FRG Corporate Income Tax Law, which grants a series of exemptions to corporations including public enterprises (rail, mail), the Bundesbank, certain public credit institutions, as well as small scale social funds and insurance associations, political parties, professional and union organizations, and benevolent associations and funds, corresponding exemptions will apply in the GDR. There is a tax relief for small-scale enterprises granted in form of a minor tax allowance of DM 5,000 per year, which is reduced degressively to zero for incomes between DM 10,000 and DM 20,000. Nevertheless, this allowance will not provide a tax relief for GDR companies, since the threshold profit of DM 20,000 is rather low even by GDR standards, and corporations with a taxable income exceeding DM 20,000 have to pay the full flat rate of 50 percent on retained earnings.

It is questionable whether the special provisions for integrated companies of the FRG Corporate Income Tax Law will prove useful for GDR enterprises. Preferential tax treatment of integrated companies is dependent on definite contracts, and it is very unlikely that the complex structure of GDR socialized enterprises and combines can meet the rigid conditions that allow an internal compensation of enterprise gains and losses.

Finally, the integration of corporate income tax on distributed profits with personal income tax, one of the major benefits of the FRG corporate income tax, will cause administrative problems in the short run, although it will prove beneficial to domestic shareholders in the long run. The procedural rules of realizing a rate of exactly 36 percent is not only rather complicated as the corporate tax burden has to be readjusted if profits of previous periods are distributed, this integration procedure might also be subject to modifications in the near future as a matter of harmonization of company taxation in the EC.

In addition, company profits are charged with an average business tax of 18 percent, which is deductible from the corporate tax base. Companies are not entitled to the business tax allowance (DM 36,000) offered to small scale unincorporated business.

Company net wealth will be subject to the net wealth tax as well as to the business tax component on net business wealth. Both taxes require the calculation of a reliable tax base, according to the Valuation Law. Both are under debate because of their allocative distortions and the abolition of double taxation of company net wealth on the corporate and the personal level is a permanent claim of industrial and financial interest groups.

Notwithstanding the problems of accounting and compliance, a one-to-one copy of FRG company taxation will offer GDR enterprises a modest tax burden in the first years of reconstruction and a relatively favorable return on share financing of new investment. Tax relief through favorable depreciation allowances, inventory valuations, and reserve formation will keep taxable profits low, especially in the transitional period. On the other hand, the GDR government will face a dramatic fall of company taxes compared to its traditional withdrawal of enterprise profits, and in the long run revenues from company taxation will be able to cover only a minor share of the budget.

2. The application of FRG personal income taxation in the GDR

If a one-to-one copy of the FRG Income Tax Law is adopted in the GDR, labor and nonlabor income will be taxed according to the same progressive 1990 income tax schedule, with statutory marginal tax rates rising linearly from 19 percent to 53 percent (Figure 2). GDR taxpayers will be affected by the allocative and distributive consequences of a general synthetic income tax schedule, which contrasts sharply to the current schedular GDR system, but, again, further administration and revenue problems will arise.

Prima facie, an adoption of a synthetic income tax for GDR taxpayers means a considerable reduction of progressive income taxation for private business profits and income from regular self-employment, whereas income of wage and salary earners, qualified freelancers, and members of cooperatives will face higher marginal tax rates. There is no doubt that replacing the confiscatory GDR income tax schedule by the FRG tax schedule will create a tax relief, but the effect on labor income earners, however, is ambiguous.

To calculate the change in tax burden incurred by a switch from the existing GDR wage taxation to the FRG income tax, one must consider the rules determining the tax base in both systems. According to the allowances of 1990, a single wage income earner in the FRG will pay no income tax if his annual income is below DM 9,500; for couples, according to spouse-splitting, the threshold income is about DM 16,500 and for a couple with two children DM 24,000. Since the average GDR gross wage is only about 40 percent of that in FRG, a considerably higher percentage of low income households will pay little or no wage tax under the FRG tax schedule (Table 9). In comparison to the existing GDR wage tax schedule, which reaches its top average rate for gross incomes of M 15,000 per capita, and starts with an exemption level of only M 2,400, tax revenues from wage taxation due to the FRG schedule will fall short of current GDR wage tax revenues. 9/ The average wage tax rate is likely to decline for wage income earners along the whole wage income scale. Even top income households—by GDR standards—with gross wage income about M 40,000, will face average wage tax rates still below those pursuant to current preferential GDR taxation, since allowances and spouse-splitting keep the tax base very low (Figures 3 and 4).

Table 9.

Taxation of Wage Income on Selected Households

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Source: Statistisches Jahrbuch der DDR 1988, own calculation.

Allowances included: personal DM 5,616, child DM 3,024, lump sum allowance for special expenses DM 108 and work-related expenses DM 2,000, precautionary savings (income related).

Tax schedule I for singles, III/2 for couples (equal labour income per adult).

Distribution (percent of GDR households with income lower or equal).

Figure 3:
Figure 3:

FRG—GDR taxcomparison

Wage taxation of singles

Citation: IMF Working Papers 1990, 089; 10.5089/9781451952216.001.A001

Figure 4:
Figure 4:

FRG—GDR comparison

Wage taxation of couples

Citation: IMF Working Papers 1990, 089; 10.5089/9781451952216.001.A001

Although stimulation of economic growth will create additional income from private trade activities and self-employment, one cannot expect a rapid broadening of the national income tax base to offset the rate reduction effect in the short run, as business investments and depreciation allowances will reduce taxable income. Fiscal importance of wage and income taxes will thus be rather low in the GDR in the transitional years after an introduction of the FRG Income Tax Law, as opposed to the FRG and other industrialized countries where wage taxation covers one fourth or more of budget expenditures.

Procedures of FRG tax compliance such as the withholding of wage tax and capital yield tax at the source, and quarterly tax prepayments based on assessed income tax of the past year, have already been elements of the current socialist tax system; nevertheless, administrative difficulties must be expected through the reintroduction of the wage tax card, the ex ante application for income tax reliefs, and the increase of annual income tax assessments. Administrative costs to taxpayers and to fiscal authorities in the GDR will tend to be high.

3. The application of the FRG value-added tax in the GDR

The value-added tax will replace the present untransparent complexity of product-related levies. The introduction of the VAT will be associated with major price movements, not only through the elimination of prior unit taxes but also through price adjustments triggered by the phasing out of price administration. Whereas any market-induced price adjustment will reduce allocative distortions, the VAT will also influence budget revenues and require an adequate structure of administration and control.

The major allocative advantage of a VAT can be fully utilized only if price administration is abandoned at the same time. The effect of the VAT’s introduction on the prices of necessities should prove negligible compared to the price effects triggered by market adjustments and subsidy reductions. Nevertheless, FRG price levels will provide an upper limit of price increases for basic consumer goods. At the same time, a simultaneous adoption of the VAT and abolition of price administration will mitigate EC fears that the GDR will jeopardize EC competition and efficiency targets. The consequences of the pure tax effect may, however, be illustrated in a stylized partial equilibrium analysis where prices are given. Then, introduction of the VAT will not influence prices of export and investment goods which have been exempted from product-related taxes and will also be exempt under the VAT regime. Consumer goods and services will be charged a standard rate of 14 percent, well below the present average rate of 50 percent on industrial consumer commodities (Table 11), thus consumer prices should fall. On the other hand, consumer prices of food, public transport, and newspapers will rise, although taxed at the reduced 7 percent rate, since these goods do not bear product-related taxes now. Finally, certain goods and services will remain untaxed (such as medical and health care services, cultural and educational services); however, prices for these exempted services are likely to rise, as prerequisite goods will bear some VAT in the future, but had been tax exempt under the old socialist tax regime.

Revenues from VAT will certainly be lower than those from current product-related taxes, but these taxes must be seen in line with the central administration of prices. The GDR planning authority used to fix retail sales prices above or below industrial prices in accordance with some prevailing social target. The sum of product-related taxes net of consumer subsidies has moved close to zero since 1985 (Tables 10 and 11) and has even become negative if local transport subsidies are included, mainly because of cross-subsidization of food and public transportation. In comparison to “net product-related taxes” the VAT is likely to deliver a considerable positive fiscal contribution but will, become the most important source of tax revenues for the GDR budget in the transition period.

Table 10.

Commodity Taxes and Subsidies in the GDR

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Source: Statistisches Jahrbuch der DDR, various volumes.

Subsidies for railway fares, water supply, services and repair.

Product-related taxes minus food and non-food subsidies.

Table 11.

Commodity Taxes and Subsidies

(In percent of total retail turnover)

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Source: Statistisches Jahrbuch der DDR, various volumes; own calculation.

Food and nonfood subsidies.

Nonfood subsidies.

If a VAT is introduced in the GDR also trade between the Germanys will have to be treated according to VAT principles. Since the GDR is not regarded as a foreign country under the German constitution, general VAT regulations on exports and imports do not apply. There are essentially three alternative solutions to the intra-German business taxation: (1) a border adjustment procedure might by implemented by decree, however, such a solution runs counter to the unification target and to the EC objectives of an internal market; (2) anticipating future unification, a common market approach may be chosen, extending the invoice method to transnational VAT credits; however, in this case, some bilateral transfer mechanism will have to be established, as the expected bilateral trade surplus will shift VAT revenues from the needy GDR to the FRG fisc; and (3) the deferred payment approach might be applied between both countries, by granting tax refunds to the “exporter” only upon proof of VAT payment to the “importer’s” fisc. 10/ An implementation of this concept will basically reproduce the revenue distribution of the destination principle through border adjustment.

The change to VAT will create several problems to tax administration and the private sector. For vertically integrated enterprises and combines that are used to calculating and paying product-related levies several times a month, a monthly VAT return may even turn out to be an administrative alleviation. Customs authorities should be able to handle the VAT on goods imported from non-EC countries without major additional costs.

The VAT will also be charged on value added at consecutive production and trade stages, which up to now have been widely exempted from the turnover tax in the GDR. Here an implementation of a multistage VAT requires additional costs in compliance and bookkeeping. To keep these costs low, the FRG VAT Law provides simplified calculation procedures for nonitemized VAT credits, especially for craftsmen and service branches. Furthermore, the exemption threshold for VAT filing (currently DM 25,000 per year) might be extended to exempt small scale private business activities from VAT filing during the transitional period. This last regulation does not necessarily imply a major competitive distortion, as only value added is tax exempt, whereas the VAT levied on goods and services purchased by the entrepreneur is not credited. Difficulties in administration and compliance can certainly be eased by the help of FRG civil servants who have become familiar with the VAT system in the last two decades and who may act as administrative advisers to GDR tax authorities during the transitional period.

4. Introducing other indirect FRG taxes in the GDR

A one-to-one copy of the FRG tax system also requires the adoption of a variety of complementary taxes.

An implementation of FRG excise taxes will provide the GDR budget with some lucrative sources of government revenue. Although excises will be a new element of GDR tax system, certain luxuries have been heavily burdened by high product-related taxes. Excise taxes on tobacco, spirits, beer and petrol will thus only partly re-establish price-deterrent effects, which have been hidden in administered GDR sales prices up to now (Table 12). If producer prices converge in the common German market, an imposition of FRG excise tax rates will cause no major changes of the prevailing price levels of these commodities after the currency swap. The only exception will be coffee, where despite the FRG’s coffee tax, the consumer price will fall by 75 percent. Other debatable excises on sugar, salt, tea and electric lamps do not create major tax wedges and are of negligible fiscal importance.

Table 12.

Retail Sales Prices on Consumer Goods

(Prices in DM and M)

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Source: Statistisches Jahrbuch der DDR 1988; Statistisches Jahr der BRD 1988 and 1975; Handelsblatt, 27.3.1990.

The adoption of the motor vehicle tax will reduce the user costs of cars for private GDR motorists, as the present GDR tax rate is higher than the FRG rate (M 18 versus DM 14.40 per 100 ccm). Furthermore, temporary tax holidays are granted for new cars that satisfy international anti-pollution standards (3-way catalysts). Nevertheless, GDR tax revenues will increase as motor vehicle tax exemptions (e.g., for vehicles used by socialized enterprises) will be abolished.

Capital transfer taxes and the insurance tax will be of minor fiscal importance in the transitional period, although their effect will likely prove counterproductive by distorting the development of capital and insurance markets.

The introduction of the real estate acquisition tax, which has always been part of the general GDR tax system, will likely raise considerable public revenues, if state-owned real estate is sold to companies, entrepreneurs, farmers, and private households. Nevertheless, net fiscal revenues will occur only in second round land sales among private agents, as the tax on privatization sales of land would have been siphoned off by higher land prices attainable by the State.

The real estate tax will only gain importance as a source of revenue when a major share of socialized property has been sold to private enterprises and households. Therefore, an immediate application of this tax is recommended for two reasons. On the one hand, property taxes, implemented as communal real estate taxes, are an important element of fiscal federalism, which had been abolished in the GDR and in other socialist societies. On the other hand, real estate taxation might serve as a proper device for siphoning off capital gains accruing to private property holders.

5. Some adjustments to the adoption scenario

The discussion of a hypothetical implementation of a one-to-one copy of the present FRG tax system in the GDR has highlighted some of the major problems of the adoption scenario, such as short-term budget problems through low tax revenues, high costs for administering sophisticated tax rules, or implementation and efficiency costs for complementary taxes, which may soon be abolished. These problems indicate that the adoption scenario can only recommend the introduction of the VAT and the major excise taxes without further adjustments, whereas qualifications appear indispensable for personal and corporate income taxes and a series of complementary taxes.

a. Company taxes

Many GDR companies will face transitional losses. The Corporate Tax Law for the GDR should impose less rigid rules to allow for horizontal and vertical offsets of losses within integrated companies.

Profits will be rather low for GDR enterprises in the transitional period, as well as for newly established enterprises. Generous depreciation rules seem necessary for new investments compared to depreciation allowances for the existing capital stock.

The complex procedure of corporate tax corrections for profit distributions according to the allocation of net equity should be replaced by a simple corporate tax rebate on dividends and other forms of profit distribution.

The business tax should be levied on the same tax bases as the personal and corporate income taxes and the net wealth tax.

Although direct company taxes are not likely to provide major fiscal revenues in the transitional period, returns from public ownership of means of production and land must be considered as a source of budget financing. The fiscal authority will be forced to examine carefully the possibilities of “dividend payments” of socialized enterprises and sales of nationalized property to the private sector. Nevertheless, profits of the socialized sector will be squeezed compared to former planned net profit targets by competitive commodity prices and higher costs, including market interest payments and higher social security contributions. Thus, budget revenues from dividends and privatization are likely to achieve only minor contributions to the government budget.

b. Personal income taxation

To reduce the likely shortfall of income and especially wage tax revenues, FRG tax parameters might have to be temporarily adjusted. The most appropriate measure from a fiscal point of view would be the basic allowance, which determines the tax threshold. Nevertheless, the social and political costs of reducing the basic allowance and charging low-paid GDR workers a higher income tax burden than their higher-paid FRG compatriots is likely to be unsustainable by triggering a new wave of emigration to the West.

An alternative device to avoid an erosion of the tax bases is the suspension or abolition of child allowances and replacing them by a system of direct transfers, targeted directly at lower private costs of child care and education in the GDR.

The FRG tax rules on special expenses are complex and should be suspended. Compulsory contributions to social insurance can be treated as work-related expenses and deducted accordingly.

c. Complementary taxes

Complementary taxes will have to be introduced to avoid allocative distortions and opportunities of rent-seeking by cross-border tax arbitrage. On the other hand, there is an urgent fiscal need for some of these taxes to finance the GDR budget.

It will be necessary to follow a step-wise implementation of the FRG tax system in the GDR, deferring the adoption of taxes which might not be levied in a united Germany in the Internal Market. GDR should not introduce the excise taxes on sugar, salt, tea, sparkling wine and electric lamps, as well as capital transfer taxes and the tax on exchange bills.

d. Concluding considerations

Although a selective adoption of current FRG taxes runs counter to the general target of implementing the whole balanced tax system to promote comprehensive political unification it appears to be indispensable to adjust FRG tax laws to financial requirements of the GDR budget as well as to affordable administration and compliance costs. There is no doubt that the modifications, which should prove helpful to the GDR transition process, can be integrated into an adjusted FRG tax Law. Nevertheless, in such a process a broad variety of complexities and political trade-offs, which have contributed to the erosion of tax bases and to tax inconsistencies, will survive, as they have done during recent tax reforms.

Although the State Treaty explicitly requires the adoption of the FRG tax system by the GDR, there is a legal leeway for an adjustment of FRG tax rules. Deviations are feasible with respect to the Treaty, if the FRG government agrees. Political statements favoring the adoption approach in the FRG have been rather general, although there is political lobbying in favor of a selective adoption approach 11/, which grants major business tax relief. Thus there is an urgent need to analyze the direct and indirect costs of implementing single FRG tax laws in the GDR to ensure that FRG concessions for deviations are agreed where they are founded economically to support the GDR transition toward a market economy.

IV. A Tax Reform Scenario for the GDR

In centrally planned economies, “taxes” have mainly been used as an instrument of central planning and thus traditional socialist tax systems can hardly be regarded as a suitable basis for a market-oriented tax reform. Consequently, and in contrast to comprehensive tax reforms in market economies, a tax reform in a centrally planned economy therefore requires a rebuilding of the entire system from scratch. In principle, this is true for the GDR as well. Examples from CMEA countries, like Poland and Hungary show that the design and implementation of an adequate tax system is an economically and politically tedious task. The GDR’s option to import the FRG tax system is an exceptional case, based on the unification target.

Although, given this political constraint, the arguments in favor of the adoption approach are rather convincing, there are at least four major arguments suggesting it may be worthwhile to recommend an independent tax reform scenario for the GDR:

(a) The FRG tax system, like any other tax system in an industrialized democratic society, is the result of political compromises on conflicting targets, including economic and social goals as well as the financial needs of governments. 12/ The GDR, in its first steps toward a market economy, certainly has not the slightest similarity to the highly developed FRG economy; in the GDR the demand for public goods, the presence of externalities, the pattern of social equity targets as well as the affordable level of the public sector budget are quite different. Even an optimal FRG tax system will, therefore, not meet the consumer preferences and economic constraints in the GDR economy.

(b) The FRG coalition cabinet has repeatedly announced that it is willing to reform business taxation. The necessity of such a reform is documented in various reform proposals of political parties, interest groups, and independent experts. 13/ An adoption of the current FRG tax system will nonetheless force the GDR to undergo further tax policy changes within a short period of time to move toward unification in step with the FRG. 14/

(c) EC directives on a further harmonization of direct and/or indirect taxes as well as international tax competition will induce tax reform measures in the FRG and, consequently, in the GDR.

(d) Tax policy has become a central policy issue in Western democracies. The tax reform issue will offer a valuable opportunity to exercise democratic procedures in the new GDR parliament, whereas the adoption of the FRG tax system might degenerate in a detrimental debate on heteronomy and economic force. The young GDR democracy should not be relieved of its responsibility for economic decisions on tax policy issues, and this must include the discussion of realistic alternatives to the adoption approach.

Since the GDR’s clear majority vote for political unification reveals a plea for market-orientation against central planning and administered pricing, the economic objectives of an autonomous tax reform will not differ from general tax policy goals in any other market economy, such as efficiency (allocational neutrality), distributional equity (horizontal and vertical equity, transparency), simpicity (low costs for administration and control) and fiscal sufficiency (provision of budgetary needs). However, the GDR tax reform must also pay attention to the political objective of unification, which implies a further target: compatibility (with the FRG tax structure to reduce the costs of phasing in a common tax system at some suitable future date).

According to this catalogue of objectives, the adoption scenario may be characterized as a strategy where the compatibility target dominates all other targets lexicographically. An economic objective function, however, has to consider trade-offs between the various conflicting targets and might arrive at another result allowing some temporary deviations from the FRG tax system in order to improve GDR welfare, especially in the transitional period.

The starting point of an independent GDR tax reform scenario to back the transition toward a market economy cannot be the traditional socialist practice of arbitrary profit transfers and administered commodity prices. The GDR is offered another possibility, namely, to go back to the general tax code which, though still in force, has only been applied to a few private activities in the past. Despite some major socialist deformations, these tax laws still show marked similarities to todays FRG tax system; and it is this peculiarity of common roots which gives the GDR tax reform scenario an additional appeal.

The tax reform scenario outlined below takes this basic structure of general GDR tax laws as a starting point, including the reform measures of March 1990. It eliminates socialist tax exemptions and confiscatory tax deterrents, and pays attention to the FRG’s experience in developing their tax system in the last 40 years. Since the reform scenario also allows the anticipation of some important tax reform targets, which are regarded urgent in the ongoing tax reform discussion in the FRG, the reform scenario need by no means jeopardize the German unification target or cause severe adjustment costs if political unification of both Germanys implies a common fiscal structure. Rather, the reform scenario may serve as an exceptional opportunity to redesign a tax structure for a united Germany, not from its current FRG pattern but from its historic roots four decades ago. The FRG’s economic and political experience in tax reforms will be extremely helpful to the GDR in developing a tax structure for its transition toward a market economy.

1. Toward a reform of GDR company taxation

The main objective of a GDR company tax reform is to abolish the selective treatment of different enterprises. This can be done by eliminating the production fund levy and the net profit transfer and applying the Corporate Income Tax Law to all incorporated enterprises. Socialized enterprises and cooperatives will then be subject to unlimited corporate tax liability if they are turned into companies and, until then, as commercial enterprises owned by public bodies. 15/ The exemption clause for special cooperatives must be cancelled.

The existing GDR corporate income tax is a classical corporation tax, no integration is provided for distributed profits. The tax reform bill of March 1990, however, introduced a reduced rate of 36 percent on distributed profits in accordance with current FRG tax rates. Consequently, double taxation of dividends still deters distribution and favors retaining profits. Nevertheless, the classical system is regarded as rather appropriate for economies in an early stage of development (see e.g., Musgrave, 1987, p. 256f.), when savings out of retained earnings are the only important source of private savings. Such an incentive to retain earnings, although contrary to current FRG rules, 16/ should also prove beneficial to GDR enterprises if tax rates are chosen appropriately. Furthermore, a tax rule concerning company losses (basically following the FRG unlimited carry-forward, two-years carry-back) 17/ and on profit transfers within integrated companies should be amended.

Depreciation rules are dealt with in the (personal) Income Tax Law, which the Corporate Income Tax Law generally refers to as far as the determination of taxable income is concerned. Depreciation according to ministerial orders will have to be replaced by straight line and/or declining balance regulation. In fact the Tax Reform Bill of March 1990 introduced a favorable accelerated depreciation rule into the GDR Income Tax Law which allows a write-off of a broad range of private business investments within three years. In face of high investment needs as well as problems in accounting and bookkeeping in the socialized sector, however, a cashflow concept allowing full expensing of capital investments might prove useful.

Further guidelines for the reconstruction of GDR company taxation may be derived from FRG reform targets. On the one hand, effective tax rates in the FRG are less favorable compared to other countries. Double taxation of corporate profits (corporate income tax and business tax) as well as multiple taxation of corporate net worth (corporate wealth tax, business tax, real estate tax, personal wealth tax) put a higher tax burden on the average investor than in other EC countries. In the early 1980s, effective tax rates on investments from retained earnings in the FRG were double those in the UK, 18/ and the situation has not improved for FRG investors following the recent tax reforms. On the other hand, effective tax rates and, conversely, returns on real investments still differ markedly among sectors, types of investment, sources of financing and ownership (see King and Fullerton, 1984, p. 149ff.). Although it is possible to escape playing field anomalies by arbitrage, which reduces effective tax rates considerably, there are information and adjustment costs, which will become more important in the internal market. Reform concepts for business taxation comprise an abolition of the business tax, a reduction of corporate income tax on retained earnings, an exemption of incorporated enterprises from net wealth tax, 19/ an extension on the corporate income tax integration including retained earnings (see Engels, 1989, pp. 345ff. or Frankfurter Institut, 1989) and a switch to cashflow taxation or expenditure tax concepts (Rose, 1990; Sinn, 1987).

The confiscatory corporate income tax rates have already been reduced to a top rate of 60 percent in March 1990. Considering the discussion in the FRG and tax reform measures in other European countries, a switch toward a flat rate between 30 percent and 40 percent would not only present a competitive advantage compared to the current rate of 50 percent in the FRG, but also compared to corporate income tax rates in other European countries. 20/

The business tax should be suspended, thus there is no need for a reform of the Business Tax Law. With respect to the long-lasting debate on double taxation of corporate wealth by the net wealth tax, there still seems to be a case for levying the tax, but at a reduced flat rate between 0.5 percent and 1 percent, and to credit it against the personal wealth tax liability. 21/ Contrary to the present regulation in the FRG flat rates for taxing company and personal net wealth should be equal and, thus, credits would only occur in exceptional cases. 22/

A reform of enterprise taxation in the GDR along these lines might be a useful guideline for company taxation in a unified Germany. One of the major impediments to enterprise tax reforms, the replacement of business tax revenues to local governments, might loose importance as unification in any case will demand a major reform of the German system of intergovernmental fiscal relations.

2. Toward a reform of GDR income taxation

GDR income taxation has been split into a series of decrees based primarily on preferential treatment of labor income earners in socialist societies. The primary reform target is to reintegrate labor income into the GDR Income Tax Law. According to the horizontal equity target, preferential treatment of different forms of income cannot be justified. Also, the compatibility target recommends a movement toward the prevailing FRG comprehensive income tax, although this is rather remote from the Schanz/Haig/Simons standard. 23/

As regards the tax base, the GDR Income Tax Law may provide a rather attractive starting point for a comprehensive income tax as it has not been exposed to the characteristic erosion of tax bases in Western tax systems. A rate cut-cum-base broadening approach can concentrate on keeping marginal income tax rates low. A tax reform aimed at avoiding efficiency losses, which hit economies with high tax rates and high rents on tax arbitrage, appears to be attainable at lower political costs than in Western democracies where tax reforms are blocked by defending group-specific tax preferences.

Political support for a new unitary schedule of the GDR income tax will depend on tax burden changes that income earners are faced with under the new GDR tax regime. The major part of taxable income will be wage income. Consequently, the new income tax schedule must be compared with the traditional GDR wage tax schedule and its effect on net household income (Table 13). The second important target of labor income taxation is budgetary sufficiency. Since wage taxes are the most important source of government revenues in industrialized societies, budgetary needs constrain distributional targets to exempt labor income earners from income taxation. On the other hand, vertical equity targets justify some graduation of the income tax schedule. Looking for a compromise in the tradeoff between prevailing average wage tax burdens and market-oriented marginal tax signals, the GDR parliament might discuss a graduation, which remains in line with present marginal rates for labor income earners but at the same time remains below top marginal rates of the FRG income tax. A possible guideline for a rate structure might be the current schedule for qualified freelancers, in a simplified version with a top marginal rate of 40 percent and three or four brackets below. 24/ A tax exempt threshold income should be granted in the form of a per capita tax credit for the taxpayer, his spouse, and each dependent child. 25/ Spouse-splitting instead of household taxation will require an adequate adjustment of tax brackets and child credits. Implementing such an income tax schedule will favor economic efficiency by low marginal rates and distributive equity by its graduation. Lacking tax preferences will keep tax administration simple and the fiscal sufficiency can be met, since the average tax rates may be chosen similar to international levels.

Table 13.

Net Household Income in the GDR

(in Marks per month)

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Source: Statistisches Jahrbuch der DDR 1987, chap.17, 286.

Wages and salaries including premia, vacation pay, bonuses, supplementary income.

Since compulsory social insurance contributions are fully deductible in the present wage tax decree, pensions from social insurance as well as subsidies in lieu of income should not be exempted but regarded as taxable income.

Wage taxes as well as social insurance contributions are withheld at the source and transferred to the public budgets by the employer. Income from business or self-employment has to be calculated according to existing rules. The wage tax and the capital yields tax withheld are credited against total income tax if tax liability is determined in an annual assessment.

3. Toward a reform of GDR turnover taxation

A general turnover tax and a limited number of excises will be necessary to replace the current system of product-related taxes. Nevertheless, a generalization of the existing GDR cascade-type turnover tax does not seem desirable even for a transitional period. Here an immediate switch to the FRG-type VAT is recommended, and the arguments for the adoption scenario apply.

EC targets, German unification, and, above all, revenue requirements recommend the introduction of excises on petrol, tobacco, and alcohol. Tax rates on these goods should be chosen close to FRG rates, but also according to budgetary targets. There seems to be no need to introduce other excise taxes, which are still levied in the FRG, although an excise on coffee might help reduce marginal fiscal problems.

4. Guidelines for a reform of complementary taxes

Some additional taxes of the general GDR tax code are recommended to complement the above-outlined basic tax structure:

There should be a tax on all motor vehicles, and thus the exemption for socialized enterprises should be cancelled. Tax rates on cars and trucks should be determined calculated according to road-user costs. Tax relief on new cars with catalytic converters do not seem helpful in the transitional period, pollution control should be promoted by setting standards and requiring regular emission checks.

Real estate tax exemptions should be abolished in order to tax capital gains on private property. General application of the tax will immediately burden land owners through capitalization, although taxes will be paid annually. Revenues should be passed on to local authorities as soon as their fiscal autonomy is re-established.

Tax rates on real estate transfers should be reduced to FRG levels after exemptions have been abolished.

The tax reform scenario also offers the opportunity to introduce some other taxes, which have not been applied in the GDR until now. One major objective of such taxes is raising revenues, but they may also be introduced to avoid competitive distortions in the common German market. Candidates for new GDR taxes are those that are now levied in the FRG, such as the insurance tax. There might also be some allocative leeway for specific taxes during the transitional period, which are not levied in the FGR, for example a tax on new motor vehicles (as in the UK and in the Netherlands).

V. Agenda for a Tax Reform in a United Germany

The two above-mentioned scenarios are short-term concepts, chosen for the GDR’s transition toward a market economy. In the medium-term, price differentials between the two Germanys will tend to disappear, since lower wages, lower prices for housing and consumer necessities, and lower costs of capital through tax preferences cannot be upheld in a common market. Administrative problems will also cease to be a major impediment to a unified tax system.

A medium-term agenda for a tax policy in the united Germany will have to face at least three main issues:

(1) The united Germany’s tax system must not discriminate against German competitors in the Internal European Market. Inefficiencies and higher tax burdens put at risk expected national welfare gains from European integration and from economic globalization. Tax reform measures will be necessary to eliminate weaknesses in the unitary German tax system.

(2) Abolition of national borders in the Internal Market offers leeway for new economic activities and tax arbitrage. To avoid social costs and national welfare losses associated with tax-induced rent-seeking, EC countries must look for a common strategy to close major tax loopholes. Once EC directives or international tax agreements are settled, the unitary German tax system will also have to be adjusted.

(3) The financial needs of regional and local governments will exhibit higher dispersion in a united Germany, as long as major gaps in public infrastructure and social goods provision prevail between the eastern and western parts. The current FRG system of intergovernmental fiscal relations will not be able to solve this problem, since the system essentially aims at equalizing per capita tax revenue among the lower-level governments (referred to as Laender in the following). If the predominance of the central level in German fiscal federalism is reduced, and deviations of the current structure of federal tax legislation and revenue sharing is moved toward a decentralization, the tax system will have to be adjusted accordingly.

1. Internal tax reform

Major shortcomings in the FRG tax system have already been identified above. Complexity, a lack of transparency, welfare losses due to discriminatory double taxation, and tax loopholes created by legal and administrative shortcomings, have necessitated reform proposals.

In recent years, demand for tax reform has concentrated on business taxation. Reform proposals made by special-interest groups and the Council of Economic Advisers 26/ comprise measures to reduce and equalize the top rates of personal and corporate income taxes below 50 percent (48 percent and 46 percent are suggested), extend corporate income tax integration to retained earnings, replace the business tax by a neutral (communal) business tax on value added, or abolish the net wealth tax.

Proposals on personal income taxation call for a further extension of tax cut-cum-base broadening. Efficiency losses are intended to be mitigated by lower tax rates, broader bases should help to close tax loopholes and to secure revenue targets. On the other hand, the German Council of Economic Advisers has suggested a 20 percent increase in basic allowances and child allowances. This measure will lower the average tax rate and essentially generate an income effect, whereas progressivity and distorting substitution effects remain.

Academic recommendations to reduce allocative distortions of income taxation by a move toward cashflow taxation and to extend equivalence taxation have not been acknowledged as attractive, politically supportable reform scenarios.

2. Internationally motivated tax reform

Indirect tax harmonization has reached a satisfactory level among EC countries; but administrative difficulties in operating the system in the internal market will require further adjustments at the national level. A switch to the deduction method, which would generate a fiscal distribution of value-added taxes according to the source principle, is not appreciated by the Commission despite its administrative and allocative merits.

There is an urgent demand for tax reform measures with regard to direct taxes, particularly capital taxation. International tax arbitrage activities, motivated by country specific tax preferences and by tax shelters in double taxation agreements, will increase if transaction costs go down in the internal market. EC member countries will have to react by improving international cooperation in tax administration and control, in order to keep tax evasion low. A multilateral double taxation agreement seems indispensable for the EC countries, and will likely affect corporate and capital taxation practice in a united Germany too. It is not certain whether the FRG’s full integration approach will be in line with future EC directives on corporate income tax harmonization.

International regulations within the internal market will also be required with respect to multinational corporations. Formula apportionment, negotiated multilaterally, will help reduce tax arbitrage and allocative distortions, but will hardly present a reliable base for an integrated corporate tax on retained profits.

3. Fiscal federalism

A major reconstruction of fiscal federalism will be necessary after the integration of five GDR Laender. The traditional target of FRG revenue sharing, an equalization of per capita tax income, is based on the constitutional premise of equal living conditions throughout the country. This principle has been realized by concentrating the legal power to tax at the central level and depriving Laender completely from levying taxes of their own (Table 14). Centralization of tax policy is in sharp contrast to the federal structure of the FRG State, according to the Constitution.

Table 14.

Distribution of Tax Competences in the FRG

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Source: Bundesministerium der Finanzen, 1987.

F=federal, P=provincial, C=communal, EC=European Community

Revenues from corporate and personal income taxes are shared vertically among the three levels of government according to Constitutional quota; the horizontal distribution is made with respect to local tax revenue (apart from some minor corrections, where formula apportionment is applied). Laender also keep tax revenues, which they collect pursuant to federal tax Laws such as the net wealth tax or motor vehicle tax. This procedure favors rich Laender and tends to supply them with higher revenues than might be efficient. On the other hand, an equalization mechanism is superimposed by the law on Intergovernmental Fiscal Equalization to close the gap between rich and poor Laender. Measures include a horizontal distribution of the Laender-quota of VAT (currently 35 percent) mainly per capita, a distribution of preferential shares of VAT to low income Laender, but also an equalization mechanism with direct payments to and subsidies from an equalization fund. Thus, Laender which are favored by the equalization mechanism are supplied with higher revenues allowing them to invest in public programs, which they might have recognized as unaffordable if they had to rely on their own financial resources.

Regional disparity is likely to increase in a united Germany and one must question whether the traditional equalization mechanism can be retained. The five eastern Laender will exhibit a far less comfortable public infrastructure and a lower quality of life, which will affect the interpretation of the Constitutional premise “equal living conditions throughout the country”. An alternative view, which stresses the fiscal residuum, the cost/benefit relation of public activities, instead of absolute public benefit levels may prove more appropriate with respect to the federal structure of the united Germany and to consumer sovereignty as well. A discussion of these different interpretations is not only an economic issue, but also a legal necessity, since increased dispersion of living standards in the two parts of Germany will last for some time.

This discussion may not only guide the elaboration of a new mechanism of intergovernmental transfers, it will also raise the issue of allocating tax responsibilities in a united Germany. Tax autonomy of lower level governments scarcely exists in the FRG, and it is considerably below that in countries with a comparable federal structure (Table 15). This debate appears to be all the more indispensable considering the plans to replace the local business tax, the last residual of tax autonomy, which has some fiscal importance. With respect to the basic federal structure established in the FRG Constitution, it is recommended to restructure the present distribution of tax responsibilities and to share not only tax -avenues but also the power to tax between the central and regional levels. Examples of other nations such as Canada, Switzerland, the U.S., or the Scandinavian countries suggest an introduction of regional or local surtaxes on personal and corporate income. But tax autonomy should also be extended to those regional taxes that are levied according to a federal tax law at the moment, such as the net wealth tax, the motor vehicle tax, or the real estate acquisition tax. Economic arguments in favor of a centralized tax policy (economies of scale, equitable distribution and nondiscrimination) must at least be weighed against allocational gains due to strengthened budgetary responsibility of lower level governments.

Table 15.

Revenue Structure of Regional Governments in Five Countries

(In percent of total revenue)

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Source: Lamfalussy, 1989, Table 4.

Provinces have the exclusive legal right to determine the ta

Provinces have no exclusive right, but choose tax base and t

Provinces choose the tax rate but not the tax base.

Provinces receive a fixed share of taxes determined by feder

Exclusive and competing taxes, sub-federal surcharges, and o income.

VI. Concluding Remarks

A one-to-one copy of the present FRG tax system will not be adequate to back the GDR’s transition to a market economy pursuant to problems of allocative distortions, administrative complexity and fiscal insufficiency. An adoption approach which includes adequate adjustments, however, will serve the purpose. Another feasible approach would be a reform of the present general GDR tax code.

Both approaches imply that the GDR tax system will not coincide with the current FRG tax system during a transitional period. Non-economic considerations must balance the higher degree of GDR autonomy in the reform scenario against the gain in experienced FGR consultancy in the adoption scenario.

Nevertheless, the future tax system in a united Germany will differ from that presently used in the FGR. Anticipating medium-term economic objectives of domestic and international tax reform and of fiscal federalism in the two short-term scenarios is likely to result in proposals for the GDR tax system, which are rather similar. Since the State Treaty implies a political decision in favor of the adoption approach, it is most urgent to use the feasible leeway for a flexible adjustment in the most efficient way. The two scenarios outlined in this paper may serve two purposes: (1) to provide a signal to the GDR policymakers to bear tax responsability for their own economic development; and (2) to remind the FRG policymakers that a rigid adoption device will not only strain GDR recovery but also restrict FRG tax reform options, and thus create welfare losses for both Germanys.

VII. Annex: The GDR Tax System

A breakdown of the revenues of the state budget shows that taxes (defined in the usual market economy sense as compulsory payments of economic agents to the government) are the GDR government’s most important source of revenue (Table 16). Due to the long-term pressure of the socialist government on private economic activities, socialized enterprises and combines are dominating, financing almost two thirds of total state revenues. The share of taxes paid by other economic agents is rather small, and it showed a declining trend in the last decade (Table 17).

Table 16.

State Budget Revenues in the GDP

(In millions of Marks)

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Source: Statistisches Jahrbuch der DDR, various volumes.

Change in classification since fiscal year 1987.

Table 17.

Structure of State Budget Revenues in the GDR

(In percent of total revenues)

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Source: Table 16; Statistisches Jahrbuch der DDR, various volumes.

Change in classification since fiscal year 1987

Official CDR tax statistics exclude socialized enterprises (who are alleged not to pay taxes, as the profit already belongs to the socialist State) and exhibit a share of taxes which is less than 8 percent of total government revenues (Table 18).

Table 18.

Non-state Business and Household Taxes in the GDR

(In millions of Marks)

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Source: Statistisches Jahrbuch der DDR, vol. 1988 and 1989; own calculation.

This annex covers the whole range of compulsory transfers to the state budget, including the levies of the socialized sector, social security contributions, and two user fees of fiscal importance. The Annex is organized as follows. The historical process of GDR tax policy is outlined in Subchapter VII. 1. Based on this overview, the prevailing GDR tax structure is surveyed. Traditional taxes forming the general tax code are presented in VII.2, taxation of different forms of labor income in VII.3, taxation of the cooperative sector in VII.4, and the four-channel scheme to withdraw profits from socialized combines and enterprises in VII.5. Finally, the system of social security contributions and two utilization fees, which have become fiscally important, are surveyed in VII.6.

1. Some historical remarks on GDR tax reforms

In 1945, in all the occupied parts of the former Reich, the tax system of the pre-war period was reintroduced according to a Allied Control Council decree; some modifications were made, notably a large increase in the tax rates. Thus, in the first years of post-war Germany, the same tax laws were applied to the East and to the West. With the founding of the FRG and the GDR in 1949, tax reform laws were passed in both countries, to adjust the tax structure to the major social targets.

As regards tax policy in the GDR two strands of reform activities can be distinguished, as follows:

(a) The legal tax structure of 1949 was revised several times in the following decades. Nevertheless, these revisions basically retained the original tax system consisting of the General Tax Law (Abgabenordnung), the Valuation Law (Bewertungsgesetz), and a series of specific tax laws, namely the Income Tax Law, the Corporate Income Tax Law, and the Turnover Tax Law.

(b) The application of this general tax code has been substantially eroded through additional regulations. Labor income earners as well as the whole socialized sector have been exempted from tax liabilities according to the general tax code. Instead of paying general taxes, the various types of socialized enterprises have been subject to special regulations to transfer parts of their profits to the State.

There are four measures which exempt different taxpayer groups from the general tax code in the GDR. First, a 1952 decree exempted labor income from the general income tax and introduced a more favorable tax schedule for labor income as compared to unearned income. A preferable tax treatment was offered to wage and salary earners, certain freelancers, and members of socialized production cooperatives.

Second, socialized enterprises were exempted from corporate income tax, turnover tax and property taxes according to socialized ownership. By 1957, the transfer of financial resources was replaced by a two-channel levy system, consisting of a net profit transfer and a production levy based on turnover. In 1971, this system was extended to a three-channel scheme. Besides the net profit transfer, the production fund levy and the system of product-related levies was introduced.

Since 1984, the payroll levy has constituted a fourth channel of transferring enterprise profits to the state budget. Since the early 1970s practically all industrial property in the GDR is either socialized property (Volkseigene Betriebe) or owned by cooperatives (Produktionsgenossenschaften), although basically private industrial property could still have been tolerated according to the GDR Constitution, if this property was not regarded as an economic power. 27/ Semi-state enterprises had been of some importance up to the early 1970s (6 percent of the industrial labor force in 1970), but they were nationalized completely in 1972 (Table 19).

Table 19.

GDR: Workforce in Enterprises

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Source: Statistisches Jahrbuch der DDR, various volumes.

Third, socialist cooperatives have been subject to special regulations, differing between craftmen’s production cooperatives and agricultural production cooperatives.

Finally, a special tax treatment is applied to private craftsmen, and private shopkeepers and restaurant owners, who act as commission agents of socialized enterprises.

2. The general tax code

The general tax code 28/ comprises the following ten taxes:

  • - Income tax (Einkommensteuer)

  • - Corporate income tax (Krperschaftsteuer)

  • - Turnover tax (Umsatzsteuer)

  • - Net wealth tax (Vermgensteuer)

  • - Business tax (Gewerbesteuer)

  • - Inheritance and gift tax (Erbschafts- und Schenkungssteuer)

  • - Real estate tax (Grundsteuer)

  • - Real estate acquisition tax (Grunderwerbsteuer)

  • - Motor vehicle tax (Kraftfahrzeugsteuer)

  • - Transportation tax (Befrderungsteuer)Insert Table 19

In addition to these ten taxes there are also communal taxes, such as a dog tax, an entertainment tax, and a betting and lottery tax. It can be argued that the general tax code includes all the basic elements of a multiple tax structure in an industrialized European country; however, the erosion of general taxation by special regulations has resulted in only 25 percent of tax revenues collected from private craftsmen and households, and only two percent of total GDR budget revenue coming from these taxes of the general tax code (Table 18). Lacking the proper detailed statistics, there is no further information on the fiscal importance of single taxes.

The movement toward a market economy has led to a Tax Reform Bill in March 1990. 29/ The reform measures focus on private business taxation. Confiscatory top tax rates on personal income were reduced from 90 percent to 60 percent and on corporate income from 95 percent to 60 percent. The tax rate on personal and corporate net wealth was reduced from 2.5 percent to I percent. In addition, an upper limit of 75 percent was introduced to the cumulated tax burden from direct taxes on enterprise profits. Generous accelerated depreciation allowances are granted to a fairly wide range of business investments, which allow a write-off up to 50 percent in the first year. Finally, double taxation of corporations was reduced by splitting the corporate tax rate. Distributed profits are taxed at 36 percent as in the GDR. A tax credit of 22.5 percent of dividends is deductible from the income tax of resident shareholders.

The description of the taxes of the general GDR Tax Code in the following subchapters does not include the measures introduced by the Tax Reform Bill of March 1990.

a. The income tax

Individuals who receive income from one of the following six sources are subject to income tax Liability:

  • - Agriculture and forestry

  • - Trade activities

  • - Self employment

  • - Investment property

  • - Rental and leasing

  • - Explicitly specified other types of income e.g., life annuities (EStG, para. 22). 30/

Residents of the GDR are taxed on their worldwide sum of these six sources of income (unlimited tax liability); nonresidents have to pay income tax on their income earned in the GDR (limited tax liability). Labor income earned as an employee, as a member of a cooperative, as a private craftsman, or as a qualified freelancer is not included in the enumeration and thus not taxed according to the Income Tax Law (EStG).

Pensions and social incurance compensations, social transfers, public awards, scholarships are tax exempt (EStG, para. 3). Taxable income is calculated either as the surplus of receipts over business and income-related expenses or as the difference in the net value of enterprise property. Depreciation allowances are permitted according to an official catalog, approved by the Minister of Finance.

Allowances for nonbusiness expenses are limited to social insurance contributions up to an annual limit of M 500 (increased by M 300 per capita for the spouse and for dependent children). Extraordinary expenses (costs in connection with disease, death of a relative, accident, subsidization of a relative, personal handicap) entitle an applicant to tax relief, as long as the annual income is below M 20,000 (M 36,000 for the handicapped). Marital status of the taxpayer is taken into account by granting allowances for the spouse and dependent children. Tax relief is further provided in a parent allowance (if parents are old or unable to work), and by an old-age allowance (men over 65, women over 50). These allowances (generally M 600 per year) are means-tested, and only given to income earners with less than M 20,000 a year (EStG, para. 32a).

The graduated schedule applied to the tax base calculated by these rules (base schedule K, Table 20) is extremely progressive for income levels up to M 40,000 (Figures 5 and 6), and confiscatory for higher tax bases with a top average rate of 90 percent and marginal rates of 95 percent and 98 percent for broad income intervals between.

Table 20.

GDR Income Tax Schedule (Basic Schedule K)

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Source: Income Tax Law (Sept. 18, 1970).

Transformed.

Figure 5:
Figure 5:

GDR income tax (schedule K)

Marginal and average rate in %

Citation: IMF Working Papers 1990, 089; 10.5089/9781451952216.001.A001

Figure 6:
Figure 6:

GDR income tax (schedule K)

Liability and residual progression

Citation: IMF Working Papers 1990, 089; 10.5089/9781451952216.001.A001

Due to the fact that an income tax schedule with such extraordinary progressivity levels (Table 21) stifles economic activities, even if they are desir