Abstract
The conceptual framework of this paper assumes that macroeconomic performance depends on the interplay between the economic environment and policies. Declining labor shares, wage moderation, and employment performance in Germany and the Netherlands have been presented. A number of policy changes are under way, but additional reforms may be needed to fully reap the benefits of the new economy. The tax reform package marks a radical and constructive shift in German tax policy, and the pension system requires a sea of change in public policy reforms.
IV. Tax Reform54
93. Tax reform has been a long time coming to Germany. While others have embarked on rate-cutting and base-broadening reforms along the lines of the 1986 US reform, Germany has come to look increasingly an outlier in international tax comparisons, characterized by high statutory tax rates on both business and personal income levied on relatively narrow bases. Now, however, Germany has embarked on fundamental reform. This process began last year with the Tax Relief Act of 1999/2000/2002, focused on the rate and allowance structure of the personal income tax (PIT), and culminated in a reform of business taxation that was approved by the Bundesrat on July 14, 2000.55
94. The reform package is a bold and sweeping attempt to deal with weaknesses of the pre-existing system that were being increasingly exposed by tax reforms both elsewhere in Europe and more generally. At about 47 percent of GDP, the ratio of general government revenue to GDP in Germany is around the EU average. Much of that revenue has been raised, however, by applying relatively high statutory tax rates to relatively narrow bases. Most strikingly, corporation tax raised less than 2 percent of GDP throughout the 1990s despite a statutory rate on retained earnings of 45 percent for much of the period.56 The personal tax too was marked by high rates and an eroded base. Moreover, the system was rendered complicated and opaque by the number and complexity of, and interaction between, distinct charges. The package emerged from a consensus on the need for fundamental reform.
95. This chapter reviews key elements of the package of income tax reforms.57 It starts with an overview of the reform (Section A), then focuses on key aspects of the changes to business taxation: effects on finance and investment (Section B), the change in the tax treatment of dividends, which has a wider significance to the development of corporate tax structures in the EU (Section C), and—one of the most widely noted aspects—the exemption of inter-corporate capital gains (Section D). Tax reform in so significant a country as Germany may well generate responses from other countries, and domestically too may also induce changes in the local trading tax: these issues are explored in Section E. Section F turns to labor market aspects, and Section G concludes.
A. Overview of the Reform
Key features of reform
96. The deepest structural reforms are to the corporate tax. At present—the reform takes effect on January 1, 2001—retained profits are taxed at 40 percent and distributed at 30 percent. There is currently “full imputation,” the corporate tax paid on distributed profits being treated as a prepayment of the shareholder’s liability to personal income tax on those dividends58 (the rationale of this being to avoid double taxation of dividends, at both personal and corporate levels): in effect, distributed profits are untaxed at corporate level but subject to a 30 percent withholding tax that is fully creditable against personal tax. Under the new system, all profits will be taxed at 25 percent and imputation replaced by including in the base of the PIT only half of the dividend received.
97. The situation is complicated—both before and after-reform—by the presence of two other taxes. First, a “solidarity surcharge” of 5.5 percent is levied on corporate tax payments (and on many other taxes), so that the post-reform rate of taxation is effectively 26.375 percent. Second, businesses are liable to local trading taxes (Gewerbesteuer)59 that bring the combined marginal rate under the new system to an average of around 39 percent,60 varying between about 36 and 42 percent. This compares to a combined rate on retained earnings under the current system of about 52 percent.
98. The principal base-broadening measure is a substantial reduction in depreciation allowances. For movable assets, the maximum permissible rate of declining balance depreciation61 is reduced from 30 to 20 percent; for buildings, the allowable (straight line) rate is reduced from 4 to 3 percent. Small and medium sized enterprises (net worth below DM 400,000), however, will continue to be able to create tax-free reserves equal to 50 percent of the cost of assets they intend to acquire. This has been identified by the Code of Conduct group of the EU as an instance of harmful tax competition, and in initial versions of the reform package was slated for removal.
99. One of the most widely discussed of the reform measures is the exemption from corporation tax of capital gains on shares in other corporations that have been held for more than one year (with effect from 2002).62 This seemingly technical issue has particular importance in Germany because of the extent of such corporate cross-holdings, stemming especially from acquisitions by banks. To the extent that the prospect of taxation on the realization of gains on such holdings has discouraged their disposal, exemption is seen as having a powerful effect in unfreezing equity markets: the Dax rose nearly 7 percent on announcement of this measure; and the unanticipated success of the July negotiations led to a 6.9 percent increase in the value of Allianz, one of the largest cross-holders.
100. The main changes in the PIT, summarized in Table IV-1, are the sequenced cut in marginal tax rates, increase in the basic allowance and reduction in the level at which the highest marginal rate applies.63 In some respects the changes are somewhat less dramatic than may at first appear. The increase in the basic allowance barely keeps up with inflation: assuming inflation of 2 percent per annum, the real increase between 2000 and 2005 is less than 1 percent. And the unusual way in which the tax schedule is specified in Germany—the marginal tax rate varying continuously rather than being constant within wide bands—means that the “headline” entry marginal rates apply only over rather restricted ranges of income: whereas a household earning DM 1 over the basic allowance will (in 2005) pay tax at a marginal rate of 15 percent, for instance, one earning DM 1,000 more will have a marginal rate of 15.9 percent. Nevertheless, the sequence of reforms clearly produces a substantial restructuring of the tax schedule.
Changes in Personal Income Tax
Excluding solidarity surcharge.
DM, for a single taxpayer.
101. Average rates of tax fall significantly throughout the income range: hence the large revenue cost of these changes reported below. Figure IV-1 shows the change in marginal tax rates between 1998, prior to the start of the process, and 2005, at its conclusion. At the two extremes of the distribution, the cut in the marginal rate is large. At intermediate income levels—in which many taxpayers are likely to be located—the cut is less significant.
Germany: Marginal Income Tax Rates
(In percent)
Citation: IMF Staff Country Reports 2000, 142; 10.5089/9781451810424.002.A004
Source: Ministry of Finance.102. A major concern in putting together the package was to make it reasonably attractive to unincorporated small and medium enterprises (SMEs), which form a large part of the business sector in Germany. The reduction in PIT is in itself a benefit to these groups, though this was to some degree offset by the removal of an upper limit on the marginal tax rate on business income. But although the basic reform did no great harm to SMEs it gave them no benefit as striking as the capital gains exemption offered to corporations. Three concessions to this group ultimately emerged: dropping of the proposals to remove allowances on provision for planned investments referred to above, roll-over relief (not exemption) for capital gains that SMEs realize on shares in other companies and then reinvest in corporate shares; and taxation of only half the capital gains on sales of own-businesses.
Revenue effects
103. The package is sizeable. When fully implemented,64 the net effect is estimated to be a revenue loss—consolidated across all levels of government—of DM 62.5 billion, equivalent to around 1.5 percent of current GDP. The bulk of this cost is through the changes to the personal income tax. The net cost of the business tax measures reflects the offsetting effects of large gross changes from the cut in rates and broadening of the base.
Full Revenue Effect of Reform
(DM billion)
Full Revenue Effect of Reform
(DM billion)
| Overall revenue effect | −62.5 | |||
| Of which: | ||||
| Business taxes | −10.6 | |||
| Comprising: | ||||
| Cuts in corporate tax rates | −20.4 | |||
| Cuts in rates on non-corporate tax rates | −6.1 | |||
| Tighter depreciation rules | +17.0 | |||
| Other measures | −1.0 | |||
| Personal taxes | −51.9 | |||
Full Revenue Effect of Reform
(DM billion)
| Overall revenue effect | −62.5 | |||
| Of which: | ||||
| Business taxes | −10.6 | |||
| Comprising: | ||||
| Cuts in corporate tax rates | −20.4 | |||
| Cuts in rates on non-corporate tax rates | −6.1 | |||
| Tighter depreciation rules | +17.0 | |||
| Other measures | −1.0 | |||
| Personal taxes | −51.9 | |||
International comparisons
104. A key purpose of the reform is to increase the attractiveness of the German tax system relative to those of other countries. Assessing this is a complex matter (taken up in Section B below), but a simple comparison of two key tax rates—those on corporations and on the highest personal incomes—is suggestive. The first column of Table IV-3 shows that Germany will indeed have a headline rate of corporation tax that is low by international standards, and, in particular, well below the current EU average. Taking account of local taxes and surcharges, however—in the second column—the picture is less striking: these additional taxes are higher in Germany than elsewhere, so that on this more inclusive measure reform essentially takes Germany to around the EU average. The top marginal rate on personal income reached in 2005, however, is low relative to current rates elsewhere both with and without adjustment for add-ons.
German Tax Rates in an International Context
For fiscal year starting in 1999, unless otherwise indicated.
Central government basic rate on retained earnings.
Figure in (parentheses) indicates a representative figure.
Figure in [brackets] is flat rate on capital income.
With the elimination of two surcharges, falls to 33.33 percent from 2001.
From 2001.
From 2005.
For banks and corporations not listed on the Athens stock exchange, 45 percent.
From 2003, 12.5 percent.
This rate applies to income in excess of an imputed return to equity capital, the latter being taxed at 19 percent.
Includes IRAP.
Unweighted, taking mid-points of ranges.
Includes 10 point abatement to create room for provincial taxes.
Assumes Tokyo inhabitants tax and enterprise tax at mid-points of permissible range for large enterprise.
New York City.
German Tax Rates in an International Context
| Corporation Tax 1/ | Top Personal Marginal Rate 1/ | |||
|---|---|---|---|---|
| Headline rate2/ | Including surcharges and local taxes 3/ | Headline rate 4/ | Including surcharges and local taxes 4/ | |
| Austria | 34 | 34 | 50 | 50 |
| Belgium | 39 | 40.2 | 55 | 56.65–62.15 |
| Denmark | 32 | 32 | 59 | 59 |
| Finland | 28 | 28 | 38 [28] | 53–57.75 [28] |
| France | 33.33 | 39.95/ | 54 | 54 |
| Germany | 25 6/ | (38.875) 6/ | 42 7/ | 44.31 7/ |
| Greece | 35 8/ | 35 8/ | 45 | 45 |
| Ireland | 28 9/ | 28 9/ | 46 | 46 |
| Italy | 37 10/ | 41.25 11/ | 46 | 46.23–46.46 |
| Luxembourg | 30 | 36.42–39.8 | 46 | 46 |
| Netherlands | 35 | 35 | 60 | 60 |
| Portugal | 34 | 37.4 | 40 | 40 |
| Spain | 35 | 35 | 39.6 | 40.79–42.93 |
| Sweden | 28 | 28 | 25 [30] | 5.1–58 [30] |
| United Kingdom | 30 | 30 | 40 | 40 |
| Non-Germany EU average 12/ | 32.7 | 39.65 | 45.97 | 49.82 |
| Canada | 28 13/ | 34.1–46.1 (44.6) | 29 | 44.4–54.2 |
| Japan | 34.5 | (47.8) 14/ | 50 | 65 |
| Norway | 28 | 28 | 10.35 | 28 |
| United States | 35 | 35.65–42.8 | 39.6 | (46.05) 15/ |
For fiscal year starting in 1999, unless otherwise indicated.
Central government basic rate on retained earnings.
Figure in (parentheses) indicates a representative figure.
Figure in [brackets] is flat rate on capital income.
With the elimination of two surcharges, falls to 33.33 percent from 2001.
From 2001.
From 2005.
For banks and corporations not listed on the Athens stock exchange, 45 percent.
From 2003, 12.5 percent.
This rate applies to income in excess of an imputed return to equity capital, the latter being taxed at 19 percent.
Includes IRAP.
Unweighted, taking mid-points of ranges.
Includes 10 point abatement to create room for provincial taxes.
Assumes Tokyo inhabitants tax and enterprise tax at mid-points of permissible range for large enterprise.
New York City.
German Tax Rates in an International Context
| Corporation Tax 1/ | Top Personal Marginal Rate 1/ | |||
|---|---|---|---|---|
| Headline rate2/ | Including surcharges and local taxes 3/ | Headline rate 4/ | Including surcharges and local taxes 4/ | |
| Austria | 34 | 34 | 50 | 50 |
| Belgium | 39 | 40.2 | 55 | 56.65–62.15 |
| Denmark | 32 | 32 | 59 | 59 |
| Finland | 28 | 28 | 38 [28] | 53–57.75 [28] |
| France | 33.33 | 39.95/ | 54 | 54 |
| Germany | 25 6/ | (38.875) 6/ | 42 7/ | 44.31 7/ |
| Greece | 35 8/ | 35 8/ | 45 | 45 |
| Ireland | 28 9/ | 28 9/ | 46 | 46 |
| Italy | 37 10/ | 41.25 11/ | 46 | 46.23–46.46 |
| Luxembourg | 30 | 36.42–39.8 | 46 | 46 |
| Netherlands | 35 | 35 | 60 | 60 |
| Portugal | 34 | 37.4 | 40 | 40 |
| Spain | 35 | 35 | 39.6 | 40.79–42.93 |
| Sweden | 28 | 28 | 25 [30] | 5.1–58 [30] |
| United Kingdom | 30 | 30 | 40 | 40 |
| Non-Germany EU average 12/ | 32.7 | 39.65 | 45.97 | 49.82 |
| Canada | 28 13/ | 34.1–46.1 (44.6) | 29 | 44.4–54.2 |
| Japan | 34.5 | (47.8) 14/ | 50 | 65 |
| Norway | 28 | 28 | 10.35 | 28 |
| United States | 35 | 35.65–42.8 | 39.6 | (46.05) 15/ |
For fiscal year starting in 1999, unless otherwise indicated.
Central government basic rate on retained earnings.
Figure in (parentheses) indicates a representative figure.
Figure in [brackets] is flat rate on capital income.
With the elimination of two surcharges, falls to 33.33 percent from 2001.
From 2001.
From 2005.
For banks and corporations not listed on the Athens stock exchange, 45 percent.
From 2003, 12.5 percent.
This rate applies to income in excess of an imputed return to equity capital, the latter being taxed at 19 percent.
Includes IRAP.
Unweighted, taking mid-points of ranges.
Includes 10 point abatement to create room for provincial taxes.
Assumes Tokyo inhabitants tax and enterprise tax at mid-points of permissible range for large enterprise.
New York City.
105. These comparisons implicitly assume, however, that rates elsewhere will remain unchanged. Insofar as the reform does strengthen Germany’s position in the competition for mobile income, however, so others may also feel compelled to lower their rates further, a point pursued further in Section H.
B. Effects on Investment and Finance
106. The effects of the reform on incentives to invest are complex: they potentially vary, for instance, with the identity of the final investor (whether located at home or abroad, and how they are taxed at personal level), the physical nature of the investment (whether in plant and machinery, say, or in buildings) and on the means by which the investment is financed. Moreover, the reform involves changes in both the rates of tax and the basic structure of the tax rules (particularly the change in the tax treatment of dividends), making analysis far from straightforward.
107. For domestic investors—meaning a hypothetical group that will either invest in Germany or not at all—the key issue is how reform affects the cost of capital: that is, the pre tax return needed to meet the minimum post-tax return required by investors. This, in turn, depends on the way in which the firm chooses to finance itself, as shown in Box IV-1. The expressions there—derived in Appendix 1, where the underlying model is spelt out—point to the central effects of the four main components of reform.
The Cost of Capital
By the cost of capital is meant here the quantity to which a firm that acts to maximize the wealth of its representative shareholder will seek, by adjusting its level of investment, to equate the marginal product of capital. In the absence of taxation (and assuming, for simplicity, a world with no uncertainty) this would be simply the market interest rate. It is through its effects on the costs of capital that the effects of taxation on incentives to invest are traditionally examined.
These effects depend, in general, on corporate tax parameters—the rates on distributed and retained profits (denoted τd and τu respectively), the rate of imputation c, and the price of investment goods net of the present value of depreciation allowances (p*)—the marginal rate of PIT of the marginal shareholder, m, and the proportion of dividends taxable at personal level, μ. The nature of that dependence in turn depends on the marginal source of finance both when an investment is made and when the returns are realized. Under circumstances spelled out in the appendix, denoting by R the pre-tax interest rate—assuming (a reasonable approximation in Germany) that capital gains are untaxed at personal level, and for simplicity abstracting from the costs of true depreciation—the financial costs of capital under the main financial regimes are:
Under the present system, c= τd and μ=1; after reform, c=0, τd=τu, and μ=l/2.
108. First, the reduction in depreciation allowances raises the effective cost of acquiring productive assets, and so unambiguously discourages investment (at least, once the reform is in place: there is an incentive to bring investment forward before the reform, so some temporary investment boom in 2000 is likely).
109. Second, the cut in the rate of corporation tax reduces the pre-tax earnings needed to finance any given stream of gross dividends to shareholders, and so reduces the cost of equity finance. It has no effect on the cost of debt finance: since interest is deductible against corporation tax, the earnings needed to meet interest costs are unaffected by the tax rate.
110. Acting in the opposite direction, however, the lower rate of corporation tax reinforces the increase in tax-inclusive price of investment goods brought about by the cut in depreciation allowances: at a nominal interest rate of 5 percent, for example, the present value of depreciation allowances on a movable asset falls from 33 percent of the asset price to 19 percent.
111. Third, the reduction in personal tax rates on interest income raises the cost of equity finance. Instead of investing in the company, the shareholder could simply invest her funds at the going interest rate; since such interest income is now more lightly taxed than before, equity investments—both retentions and, under the half-dividend scheme, new equity—must earn a higher return in order to persuade the shareholder to put money in the company. (There is no effect through this channel on the cost of debt finance, which, as noted, is driven by deductibility against the corporate tax.)
112. The fourth component, more subtle, is the effect of moving from full imputation to the half-dividend scheme. It has been widely claimed that the reformed system will encourage retention finance. The reasoning is that whereas under the imputation system distributed profits ultimately bear only personal tax, under the reformed system they will bear both corporate tax and personal taxation at half the usual rate, with the latter being a heavier burden for those with a low enough marginal tax rate.65 For such shareholders the change in the tax treatment of dividends makes distributing profits more costly in terms of the taxes paid today.
113. But this argument is incomplete, since a decision to retain profits also has implications for taxes paid in the future. The choice in deciding whether or not to retain profits is that between taking dividends today or dividends some time in the future.66 So long as the tax rate applied to those dividends does not change, the dividend tax simply cancels out of the calculation. In effect, shareholders’ funds within the corporation are “trapped:”67 an increase in the dividend tax rate will make shareholders worse off, but since they cannot get their money out of the company without paying that tax it becomes effectively lump sum, and so is irrelevant to their decisions.
114. Thus the change in the tax treatment of dividends does not in itself affect the cost of retention finance.68 It does, however, affect the cost of finance by means of issuing new equity: for whereas retention finance is from money already inside the company and so subject to the trap of dividend taxes, subscribing new equity is to put money into the trap, with no way of earning a return—either directly or through selling at a capital gain—that is not ultimately subject to dividend tax. While the reform does not encourage retention finance by making it cheaper in an absolute sense, it does favor it by making it cheaper relative to new equity.69
115. Combining these effects, there are few clear-cut conclusions except that (at any given world interest rate) debt-financed investment becomes more expensive. The impact on the cost of capital becomes an empirical question; or, more precisely, one of the assumptions made on the identity of the marginal shareholder and the underlying pattern of true depreciation. Taking the special case of a top-rate shareholder investing in movable assets attracting depreciation at the maximum rates, the results in Box IV-1 point to an increase in the cost of capital for all three sources of finance, and particularly for debt and new equity finance.70
116. More detailed studies tend to reach broadly the same conclusion. Bond and Chennells (2000)—who ignore personal tax effects—find significant increases in the costs of both debt and new-equity financed investments: from71 3.8 to 7.5 percent and from 11.2 to 14.0 percent respectively, leaving these amongst the highest for the set of industrialized countries they study.72 Retention finance, they find, becomes slightly cheaper: the cost of capital falls form 14.8 percent to 14.0 percent. (This ignores, however, the effects of personal taxes: while that is appropriate for tax-exempt institutional investor, the lowering of personal tax rates tends to raise the cost of retention finance for reasons described above.) Overall, they find a slight increase in the weighted average cost of capital for plant and machinery, from 10.6 to 11.7 percent: a level exceeded only by Japan. Making somewhat different assumptions—and now including personal tax changes (though not the full cut in the top rate agreed in the final package)—Sinn and Scholten (1999) find that for “normal investment”—financed half by retentions and half by debt—the cost of capital increases.
117. The overall impression is thus that the reform is unlikely to generate a significant increase in the aggregate level of investment by domestic investors. This does not imply, however, that the impact on investment incentives is adverse. Indeed that impact is almost certainly beneficial. To see why, it is helpful to think in terms of the marginal effective tax rate (METR) on investment: this is a summary indicator of the impact of the tax system on marginal investment incentives, and can be defined for present purposes as the difference between the cost of capital with and without taxes. The reform is likely to change the pattern of METRs in two beneficial ways. First, it appears to reduce the dispersion in the METRs across different types of investment and so assures a more efficient allocation of the capital stock. Second, and more strikingly still, it is likely that the initial METR is many cases negative—the generosity of depreciation allowances outweighing other aspects of the tax system to turn the net effect of the system into a subsidy—so that raising the METR actually mitigates a bias towards too high a capital stock. The effects of the reform on the incentive to invest faced by domestic investors thus appear to be beneficial, though they tend, if anything to make investment less attractive.
118. The decisions of foreign direct investors—choosing between locating real investments in Germany and elsewhere—depend not only on the marginal effective tax rate just described but on the average effective tax rate (AETR): that is, on the proportion of the profit earned on a project that is taken in tax.73 Even if the METR were zero in all countries (meaning that no tax was collected on projects that just break even), there would be a distinct incentive, all else equal, to locate projects that do better than break even (and so do pay tax) in the country with the lowest AETR. (The difference between marginal and average effective tax rates, and the ways in which they affect investment decisions, is illustrated by numerical example in Box IV-2). It should be emphasized that there is in general no simple relationship between METRs and AETRs. In particular, it is quite possible for a reform to increase one and reduce the other.74
Marginal and Average Effective Tax Rates on Investment
Consider a tax system that allows investment spending as an immediate deduction against tax. (This is a ‘cash-flow’ tax, but other arrangements—allowing interest to be deducted and giving allowance for true deprecation, for example—have the same effect). The examples below shows the treatment of two hypothetical investment projects under such a system. Both involve an investment of DM 100, and in each case the rate of return required by the investor—the return that could be earned by simply investing in the world capital market—is 5 percent. Both projects last only one period, in the sense that the investment goods acquired in period 1 are sold, after they have yielded their profit, in period 2. These sales proceeds are taxed, just as the initial investment was deductible (which again approximates real-world rules) Project A earns, before tax, a return of exactly 5 percent, the minimum required. Project B, in contrast, earns 20 percent. The tax rate is 25 percent.
| Project A (5 percent return) | Project B (20 percent return) | ||
|---|---|---|---|
| Period 0: | |||
| Investment | 100 | 100 | |
| Tax payment | −25 | −25 | |
| Period 1: | |||
| Receipts | 105 | 120 | |
| Tax payment | 26.25 | 30 | |
| In present value: | |||
| Pre-tax profit | 0 | 14.3 | |
| Tax payment | 0 | 3.6 | |
| After-tax profit | 0 | 10.7 | |
| Project A (5 percent return) | Project B (20 percent return) | ||
|---|---|---|---|
| Period 0: | |||
| Investment | 100 | 100 | |
| Tax payment | −25 | −25 | |
| Period 1: | |||
| Receipts | 105 | 120 | |
| Tax payment | 26.25 | 30 | |
| In present value: | |||
| Pre-tax profit | 0 | 14.3 | |
| Tax payment | 0 | 3.6 | |
| After-tax profit | 0 | 10.7 | |
The two projects are identical in period 1, when the investment is made. They cost DM 100, but the firm reduces its tax base by that amount and so reduces its tax bill by DM 25. In period 2, however, both firms must pay tax on the sales proceeds of DM 100, but there the similarity ends:
Project A earns profit of DM 5, and so pays tax of DM 26.25 (25 percent of DM 5 profit plus DM 100 receipts from disinvestment). Discounted at the investor’s rate of 5 percent, this is worth DM 25 in period 1 terms; and so exactly offsets the tax reduction of 25 DM in period 1: the present value of taxes paid is zero. So too are both pre-and post tax profits. Thus the METR under this tax system is zero: the pre- and post-tax returns are identical, with the investor earning exactly the minimum required. This is because this tax system because it gives full allowance for the costs of investment. (Clearly too the AETR on this particular project is zero).
Project B earns profit of 20 and so pays tax of DM 30 (25 percent of DM 20 profit plus DM 100 disinvestment). In present value terms, this is greater than the break of DM 25 in period. Thus the AETR is positive. Present value profits are also positive: the project remains worth undertaking even though some of the return goes in tax.
If all countries offer tax systems of this kind, but at different rates, an investor will be indifferent as to where to locate the marginal project A, but will locate B wherever the tax rate is lowest.1
1 To see more generally and precisely the respective roles of marginal and average effective tax rates, consider the investment problem of a multinational firm. This has two stages: in which country to invest and how much to invest there. For the second stage of this problem, the multinational decides how much it would wish to invest were it to choose each of the possible countries. These choices will be affected by the METRs in each country. At the first stage, it then chooses between countries by selecting the one in which the after-tax profit implied by the hypothetical investment decisions determined at the second stage is greatest; this will depend on the AETRs levied in the various countries. Allowing for the further complication that investments may be made simultaneously in several countries, a further role emerges for the statutory tax rate, since location then becomes an extreme form of transfer pricing (since it affects the cross-country split of profits). See Keen (1991) for a fairly general treatment of tax effects on multinational’s investment decisions.119. Bond and Chennells report average effective tax rates for Japanese and US subsidiaries operating in Germany (the home country of the multinational mattering in this context because of differing home country tax rules on the treatment of earnings repatriated by subsidiaries). While the results are mixed, the most striking finding is a fall in the AETR on retention-financed investment (retentions being a particularly important source of finance for subsidiaries): from 45.1 to 41.5 percent for a Japanese subsidiary, and from 41.9 percent to 37.3 percent for a US subsidiary.75 While these results in part reflect a relatively high assumed pre-tax return of 30 percent, they suggest that the cut in the statutory tax rates may have a marked effect on this aspect of incentives to invest. Even so, the AETRs achieved after reform are in many cases higher than multinationals could achieve elsewhere.76 Nevertheless, the reform does appear to make Germany a significantly more attractive country in which to locate footloose investments.
C. Imputation: An Idea Whose Time has Gone?
120. One of the most controversial aspects of the reform was the ending of full imputation. What makes the issue of special and wider interest is that imputation was at one point clearly identified77 (though not formally adopted) as a target for harmonization within the European Union. Imputation indeed spread from France to Germany, Ireland, and the UK. Classical corporate systems of the kind operated in the US—with separate taxation at personal and corporate levels—began to look a thing of the past. Now the tide has turned: the UK and Ireland have already moved back to a classical system. Thus the wider question raised by the German reform is whether this route towards integration has proved to be fundamentally flawed; or whether, on the other hand, a potentially useful development has been terminated prematurely.
121. Two main arguments were used in favor of full imputation in the German reform debate. The first is based on equity considerations: relative to a full imputation system under which distributions are taxed as personal income, those with sufficiently low marginal tax rates will lose from adoption of the half-dividend system (the advantage of paying only half their marginal tax rate being outweighed by the loss from paying tax at the corporate rate before receiving the dividend). But it is not clear that this is a significant issue in practice, and the liability of many less well-off shareholders to pay tax on their dividends will in any event be limited by the availability of a DM 3,000 allowance to set against capital income, which implies (because of the halving) that tax is payable only if dividends received exceed DM 6,000.
122. The second argument is that the merits of imputation in terms of leveling the playing field between retention and new equity finance should not be discarded lightly.78 Conversely, removing imputation biases firms against financing themselves by selling new equity, and so hampers the development of equity markets. Note though that imputation does not level the playing field between all sources of finance: as can be seen from Box IV-1, debt finance will be more attractive than equity finance to a shareholder whose marginal personal rate is below the corporate tax rate (the intuition being that the value of interest deductibility at personal level more than offsets the tax paid on interest income at personal level). The general lowering of tax rates at corporate and personal levels may reduce this distortion: but it does not eliminate it.
123. The main argument levied against imputation, however, is the potential legal objection to the denial of imputation credit to non-residents (except as provided for by bilateral treaty, as for instance between Germany and France). These were also a factor in the UK’s decision to move way from imputation, though in that case there were also keenly felt difficulties associated with the denial of credit for dividends paid to domestic residents from income that had borne corporate tax outside the UK. One way of resolving any such problems would be to unilaterally extend credits to residents of other member states, though the revenue cost could be considerable. Thus it may be that legal difficulties are taking the EU further away from achieving a desirable integration of personal and corporate taxes, a point returned to in Section E below.
D. Exemption of Inter-Corporate Capital Gains
124. The exemption of inter-corporate gains had a particular rationale, and popularity, in Germany because of its effect in unwinding substantial holdings built up by the financial sector. As a tax policy measure, however, its merits are not immediately obvious. If the purpose is to discourage inter-corporate holdings, for example, making gains on such holdings tax-free is unlikely to be the best instrument; if particular problems attach to preexisting holdings, specific measures could have been adopted targeted to those holdings (granting a one-time exemption, for example, for assets held more than some number of years). More generally, the measure marks an important departure from the normal practice—while some countries reduce the tax burden on inter-corporate gains, many tax them fully—and one which might so easily be imitated by others that its deeper rationale merits close consideration.
125. The key tax policy argument for exempting inter-corporate gains is that changes in fundamental share prices reflect changes in anticipated earnings, so that if those earnings are subject to corporation tax it would be inappropriate double taxation to tax the gain as well. Just as inter-corporate dividends are usually exempted from tax, so, the argument goes, should be inter-corporate capital gains. Advocates of the reform link this point with the move towards a classical system, which indeed changes the corporation tax into a distinct tax on corporate earnings as such.
126. The logic of the basic argument, however, can be pursued further. It can be applied at personal level to conclude that, as a matter of principle, there also should be no capital gains tax on shares in corporations. This is so, moreover, under both classical and imputation systems. Under a classical system, taxing at the personal level changes in share prices that reflect anticipated distributions on which both corporate and dividend taxes are charged would be triple taxation; and taxing gains on corporations’ shares in other corporations would imply quadruple taxation. Under full imputation, at the other extreme, the object is to ultimately tax earnings received through corporations at the personal rate. This is properly achieved by giving the shareholder full credit in respect of dividends received for underlying corporation tax paid: taxing capital gains which reflect the personal tax paid on future dividends subjects corporate earnings to two layers of personal tax. Thus one arrives at the conclusion that capital gains on shares in corporations should not be taxed at either personal or corporate level.
127. Clearly any such exemption from capital gains tax needs to be carefully structured so as to prevent avoidance by turning untaxed income into untaxed capital gains, the key being to ensure that exemption is available only when there is assurance that tax has or—more difficult, since capital gains can arise from anticipated earnings far in the future—will be paid. Two more fundamental objections to the argument for exemption are sometimes made.
128. One is to doubt whether retained earnings are necessarily fully reflected in share prices, and similarly whether share prices reflect only expected future dividends: cannot the dividend tax be avoided by never distributing profits? The essential requirement for the argument above, however, is merely that fundamental share prices ultimately be rooted in earnings, and that those earnings must ultimately be distributable if the firm is to be more than a bubble.
129. The second argument, more subtle, asserts that while it is indeed double taxation to tax gains on corporate shares that arise from the expectation of future dividends, this is exactly offset by the taxable loss—and hence reduction in capital gains tax—that arises when the dividend is subsequently paid.79 But this is not right: the subsequent reduction in capital gains tax liability when the share goes ex-dividend will be reflected in its share price prior to the dividend being paid. This effect thus washes out, leaving only that of the underlying change in earnings.
130. While opinions will continue to differ, the tax policy grounds for this measure appear to be strong; so strong, indeed, that they may well call what has previously been standard practice into increased doubt.
E. Implications for Other EU Countries and for Fiscal Federal Relations in Germany
131. The reform fundamentally alters the context in which other jurisdictions set their taxes, so that the final equilibrium to which it leads may also reflect changes in the behavior of those other jurisdictions. Responses are likely both externally, most obviously by other countries in the EU, and internally, at lower levels of government within Germany.
132. It is not surprising that Germany has had a higher rate of corporation tax than many other countries. Theory predicts80 that, all else equal (including tastes for publicly-provided goods), large countries will maintain higher tax rates than small: they have less to gain by setting a low tax rate in order to attract tax base from abroad and more to lose in terms of revenue forgone on the domestic tax base. This is especially so if that large country acts as a leader in the setting of tax rates, anticipating how others will respond when setting its own tax rate. Thus the dramatic cut in German tax rates could have a significant effect on the overall equilibrium that emerges from international tax competition.
133. Most obviously, the reduction in the statutory rate of corporation tax will put pressure on those high tax countries that now become more exposed. Since the German tax reform, France has announced the removal of a surcharge on corporation tax that will take its rate down to 33.3 percent.81 But even countries that set lower taxes than Germany may now have an incentive to cut further in order to maintain their competitiveness. To some extent the impact of the German tax cut is mitigated by the fact that Germany’s treaties generally exempt dividends received from foreign subsidiaries rather than giving a credit for taxes paid abroad: for this means that the tax cuts have no effect on the overall tax position of German subsidiaries operating abroad and so do not place pressure on other jurisdictions to cut their tax rates so as to retain their attractiveness to those subsidiaries. Nevertheless, it seems likely that the German reform will give a further twist to tax competition in the EU and perhaps also more widely.
134. The reform now leaves Finland and France as the only EU countries operating an imputation system. It remains to be seen whether it will prove advantageous for them to continue doing so, especially if the legal problems invoked in justifying the change in Germany prove warranted. It clearly seems that imputation—once the preferred form of corporate tax in the EU—has failed to resolve the problems associated with the double taxation of dividends. The wider question is whether the uncoordinated solution to which the EU is headed—some degree of double taxation of dividends—is better than that which would have been achieved with coordination, whether on full imputation with credits payable to residents of all EU states or to some other system.
135. It may be, however, that corporation tax in the EU has reached a point at which reform even more fundamental than convergence on imputation with full crediting across member states’ borders will suffice. More radical approaches to the tax competition problem—some commentators have suggested moving to a system of EU-wide of formula apportionment,82 or to an optional “European” corporation tax—may need to be entertained.
136. Within Germany, the similarity between the base of the corporation tax and that of the local trading tax suggest that the change in the former may induce a change in the equilibrium level of the latter. These trading taxes are set in an environment shaped largely by horizontal tax competition between the municipalities, tempted to attract capital by setting lower taxes than their neighbors.83 But that environment is also shaped by the vertical interaction with the corporation tax. The implications of this for the equilibrium tax structure are complex.
137. First, since the trading tax is deductible against the corporation tax, part of the cost of the increased trading tax that firms would pay if a municipality were to raise the rate at which it charges its trading tax would actually be borne not by the firm itself but by the federal government (in the form of a reduction in corporation tax receipts). This gives the municipalities an incentive to set the trading tax higher than they otherwise would. With the cut in the corporate tax rate, the federal government now bears less of the cost of an increase in the trading tax. This makes it more costly for the municipalities to raise their tax rates, and so should lead to a lower equilibrium level of the trading taxes.
138. Second, to the extent that the reform increases the base of the trading tax, so the revenue that a municipality gains by increasing its tax rate increases, making such an increase more attractive. This points towards higher trading taxes in equilibrium.
139. These effects point in opposite directions, and the overall effect is theoretically uncertain. In the simplest case in which municipalities seek to maximize revenue and the base is a linear function of the tax rate, it is shown in Appendix 2—in a very stylized model—that a cut in the rate of corporation tax will lead to higher rates of trading tax if and only if the latter is initially less than 50 percent. More generally, there are even more effects at work.84 Whether a reduction in the federal tax rate will lead to higher or lower municipal tax rates is thus is an essentially empirical question, for which—in the absence of home grown evidence—one must look outside Germany. For Canada, Hayashi and Boadway (1999) find that a cut in the federal corporate tax is associated with an increase in provincial taxes. If this pattern were to be repeated in Germany,85 the cut in the federal tax rate brought about by reform would be partly offset by increased trading taxes: the average effective rate will end up even higher than the 39 percent cited earlier.
F. Labor Market Issues
140. The general decline in average tax rates will tend to reduce the work effort of those currently employed, since the income effect of the increase in net income at initial levels of effort means that more leisure can now be afforded. Two further effects of the average tax rate reductions, however, are likely to have a more positive effect on employment: the increase in in-work income relative to that when out of the labor market is likely to increase participation rates; and by reducing the pre-tax wage increase needed to achieve any increase in net income, the average rate cuts may also tilt collective agreements towards outcomes more favorable to employment.
141. The reduction in marginal rates in itself generates substitution effects that point to an increased labor supply. The most significant cuts are at the lowest income levels—though this is somewhat over-stated by the comparison in Figure IV-1 above, since wage inflation will move taxpayers into higher incomes by 2005—and, especially, at the highest. The latter is certainly substantial—11 points relative to 1998—though how significant the work responses will be is a matter for conjecture: recent evidence suggests some caution in anticipating very sizeable effects.86 Clearly though the overall effect of reform is to change the rate structure in a way that is significantly less distortive of work decisions.
142. A notable feature of the reform package in relation to labor market performance—a contrast to recent policy developments in many other countries—is the relative modesty of targeted measures intended to improve the employment prospects of the lower-skilled. Others have sought to address very directly the concern that high taxes and social contributions may induce unemployment, although the question of whether high taxes do indeed contribute to unemployment remains contentious (it being clear that labor market institutions also matter in this context).87 Crucial in this context is the relationship between net incomes in and out of work, and the question arises as to whether more direct action on this margin is appropriate in Germany.
143. One obvious way to tilt the balance in favor of work is by restricting the duration of entitlements to unemployment benefit, which is currently unlimited. Several measures are available to increase in-work net pay at low income levels:88 reducing PIT and social contributions (as in the present reform package); subsidizing wages paid by employers (perhaps only on new hires, and perhaps only for a limited period); or making earningsrelated payments direct to workers. There are potentially important differences in their administration, but conceptually they are essentially equivalent: all change the relationship between gross labor costs of employers and net incomes to workers so as to increase the latter for any given level of the former. The principal measure of this kind adopted in Germany is the exemption from PIT89 and employee’s social contributions for jobs paying less than DM 630 for less than 15 hours work per week. France has a more extensive scheme for rebating employer’s contributions on wages up to 1.8 times the minimum wage. The US and UK have focussed instead on boosting take-home pay through the tax system, through earned income tax credit schemes.
144. While schemes of this type can in principle be self-financing, with the direct cost more than offset by unemployment benefit saved and additional taxes paid, in practice their cost-effectiveness is unclear. Thus Katz (1996) reaches a skeptical conclusion as to the effectiveness of wage subsidies unaccompanied by well-designed training measures, as for the UK do Bell, Blundell and van Reenen (1999). German policy in this area seems to betoken a similar skepticism of these non-traditional measures: experiments on the employment effects of restructuring social contributions are underway, for example, but will not yield conclusions for several years. While this skepticism may prove well-placed, it is striking how much less attention to these issues has been paid in Germany than elsewhere.
G. Conclusion
145. The reform package marks a radical and constructive shift in German tax policy. The direct impact on those aspects of behavior that are most readily quantified—and hence most widely studied—may prove modest: there may be little effect on levels of real investment (especially by domestic corporations) and on labor supply at all but the highest incomes. Clearly too there remains scope for further base-broadening,90 and the system is still complex.91 Tax reform is evidently work in progress: the weaknesses of the current trading tax, for example, are likely to become more pressing.
146. But there will clearly be very significant gains from the current package, albeit ones hard to quantify. Germany will be a more attractive place for international investors, the allocation of investment will be improved, the cut in the top rate will help retain and motivate skilled workers and entrepreneurs, and the reduction in average rates of personal taxation is likely to feed helpfully into participation decisions and employment bargaining. Above all, the reform signifies a willingness to remold tax policy, to match—and in important respects better—developments elsewhere.
APPENDIX I Derivation of Costs of Capital
147. The model underlying Box IV-1 and the arguments in the text is an essentially standard one of shareholder wealth-maximization under perfect certainty (developed by King (1974)). Arbitrage requires that the marginal shareholder be indifferent between: (a) selling the share at its current price Vt and investing the proceeds at the market interest rate R and (b) holding it, subscribing an amount VtN in new share issues, receiving dividend D and capital gain.92 Allowing for a tax on interest income at the rate m and taxation of dividends in the hands of the shareholder at rate 0, this requires that:
148. The dividend tax parameter θ reflects both the personal tax rate applied to dividends and any credit for underlying corporation tax, so that in general, in the notation of Box IV-1, 1-θ= (1−μm)/(1−c). Solving equation (1) subject to the terminal condition (1+ρ)−TVT=0 gives the valuation:
where ρ=(1−m)R denotes the shareholder’s discount rate. The final ingredient is the sources and uses condition, which implies that dividends are:
where F(Ks) denotes profit as a function of the real capital stock at time s, Ks, while Bs denotes (one-period) debt issued at time s (interest being deductible), It denotes real investment, and Js depreciation allowable at time s. The firm’s objective is to maximize the share price in (2) subject to (3) and the equations of motion on the real capital stock and tax-written capital.
149. Suppose that depreciation for tax purposes is at declining balance at rate δT, so that Js = Is− δTJs. It is then straightforward to show that the present value of depreciation allowances on an unit investment is τuδT/(ρ + δT), reducing the effective cost of acquiring an investment good from unity to p*= (1 − (τu δT/(ρ + δT)). The firms’ problem is then equivalent to one in which Dt in (2) is replaced by93
and it is this form of the problem that is pursued here.
150. The costs of capital are derived by considering a one-period perturbation of the capital stock (ΔIt= −ΔIt+1 =1) under various financing assumptions, leaving—under the simplifying assumption that capital does not depreciate—the situation of the firm at all other dates unaffected. At an optimum, the net effect of this perturbation on the share price must be zero, and from this the cost of capital can be inferred.
151. Retention finance. In this case the net impact on share prices reflects a cut in the current dividend sufficient to finance investment of p* and an increase next period that reflects both the additional earnings and the reduction in next-period investment:
which, recalling the definition of ρ, reduces to
152. Debt finance. Financing the perturbation by adjusting only borrowing (ΔBt = − ABt+1 = p*) gives a share price effect of
which reduces to the expression in Box IV-1.
153. New equity. With new equity finance
which, from the definition of θ, gives the result in Box IV-1.
APPENDIX II Response of the Trading Tax to an Increase in the Federal Tax
154. Writing the base of the tax as a (decreasing) function B(.) of the combined tax rate T+t(1-ïT), where t and T denote respectively the local and federal tax, and ï the proportion of local taxes deductible against federal, suppose, by way of illustration, that the objective of the lower-level government is simply to maximize its revenue tB(T + t(l-ïT)). The necessary condition for this,
defines t as a function of T. By the implicit function theorem, dt/dT has the same sign as -λBʹt+Bʹ(1-λt)+Bʺ(1-λT)(1-λt) (the first and second terms corresponding to those discussed in paragraphs 137 and 138), which is in general ambiguous. In the special case in which Bʺ=0, however, and with full deducibility, it is necessary and sufficient for dt/dT<0 that t be less than 0.5.
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Wagner, F. W., and D. Wader, 2000, “The Effect of the Planned Corporation Tax Reform on the Tax Burden and Tax-Related Decision-Making,” Mimeo, University Tübingen (in German).
Prepared by Michael Keen.
Formally, agreement was on a package that the Bundesrat will approve when presented as a revised bill.
This partly reflects the relatively small corporate sector in Germany.
It does not address the series of “eco-tax” measures, raising taxes on petroleum products and using the proceeds to reduce social contributions.
For example, if a shareholder receives a check for dividends of DM 700 this is regarded as reflecting an underlying dividend of DM 1000 from which DM 300 of PIT has been withheld. If the shareholder’s marginal rate of PIT is 40 percent, for instance, additional personal tax of DM 100 is payable.
The base is common to all municipalities, and while similar to that for the federal corporation tax has some important differences (most notably the non-deductibility of interest on long-term debt obligations). Each municipality then applies its own “multiplier” to the basic amount, the latter being 5 percent of the common base. Multipliers vary from about 300 to over 515 percent, averaging around 400. Trading tax payments are deductible from the base of the corporate tax.
The trading tax rate calculated by applying the multiplier to the basic federal tax is a tax-exclusive rate (that is, is charged on a base that excludes the tax itself). At a multiplier of 400 percent, the combined tax rate is thus (0.25)(1.055- (0.2/1.2)) + (0.2/1.2) = 0.38875.
Regulations specify maximum allowable rates of straight-line depreciation for a large number of distinct asset types, and allow declining balance depreciation at three times those rates up to a maximum (after reform) of 30 percent. Companies may take faster depreciation if they are able to show that the asset is actually used more rapidly.
Gains on holdings of foreign corporations were already exempt prior to reform.
The changes were initially set out in the Tax Relief Act of 1999/2000/2002; the 2000 tax reform brought forward to 2001 changes initially scheduled for 2002; and the July Bundesrat agreement cut the final top rate from 45 percent.
The transitional effects are complex, in large part because the effects of the corporate rate cuts are felt immediately whereas the revenue gain from less generous depreciation allowances accrues gradually (because assets acquired pre-reform continue to be depreciated at pre-reform rates).
At the present corporate rate on distributions of 30 percent, the critical marginal rate of personal tax is about 46 percent.
Even if the present shareholder does not expect to receive an increased dividend but rather an increased share price, that price increase will ultimately stem from the expectation of higher future dividends
On this “new” or “trapped equity” view of dividend taxes, see, for instance, Auerbach (1983).
This can be seen from Box IV-1, the cost of capital for retention finance being independent of c and μ.
This discouragement of new equity finance is essentially the “lock-in” effect that has been widely discussed in Germany. Wagner and Wader (2000), for example, show how the post-tax return from investing in a company increases with the length of the holding period, an effect reflecting precisely the benefits of delaying tax on dividend payments. Implicitly, their argument relates to the subscription to new equity, since otherwise the dividend tax avoided now by retaining profits would offset the tax on future dividend. The point is thus that the new scheme not only discourages new equity finance but encourages delaying the payment of dividends financed by the subscription to such new issues.
At an 8 percent interest rate, the costs of capital in Box V-1 (which, recall, do not include the costs of true depreciation) rise from 4 to 4.9 percent (retentions), 5.2 to 6.3 percent (debt), and 4.6 to 6.2 percent (new equity).
The figures in this paragraph are for investments in plant and machinery. The conclusions for buildings are broadly similar.
Denmark, France, Japan, the Netherlands, the UK, and the US.
See Devereux and Griffiths (1998) for an account of the average effective tax rate.
To see this, note that the METR depends only on parameters of the tax system, the true rate of depreciation and the rate of interest. Calculating the AETR, in contrast, requires some assumption on the pre-tax return earned by the particular project. (Crudely put, the METR is a property of a tax system, the AETR a property of a particular project). Thus a reform which cuts both depreciation allowances and the statutory tax rate, for example, could on balance raise the METR (the depreciation effect dominating) yet lower the AETR (because intra-marginal returns are so large that the cut in the tax rate dominates the increase in the tax base from lower depreciation).
These figures are again for investment in plant and machinery: the fall in average effective tax rates for buildings is somewhat more marked.
For example, the average effective tax rate for the same investment by a US subsidiary is estimated to be 33.7 percent in the UK and 34.3 in the Netherlands.
In a 1975 draft directive.
This argument is used, for instance, by US Treasury (1992).
See, for example, Kanbur and Keen (1993).
See the chapter on recent tax developments in the selected issues paper for France.
That is, allocating the profits of multinationals across EU member states by summary measures of their economic presence in each.
Horizontal tax competition of this sort is documented by Büttner (2000).
For instance, the change in the federal tax will typically affect not only the level of the tax base but also its sensitivity to the trading tax, which will further affect the municipalities’ decisions in setting trading taxes. Keen and Kotsogiannis (2000) analyze the response of provincial taxes to federal in fairly general circumstances.
It should though be noted that provincial taxes are not deductible against federal in Canada, so that the effect in paragraph 137 is not at work there: the presence of this effect in Germany makes it more likely that the trading tax would fall in response to the cut in federal taxation.
If labor markets are competitive, for instance, then taxes may impact the level of employment but not induce unemployment; and in fully centralized labor markets employment effect should be internalized in the bargain. See Daveri and Tabellini (2000).
These are analyzed in Chapter IV of the 1999 Selected Issues.
For taxpayers with no other income.
Prime candidates for removal include exemptions for Sunday work, night work and commuting expenses, and the allowance for second homes bought for work purposes.
In the concessions introduced for SMEs, for example, the PIT rate structure, the transition rules for movement to the half-dividend system and in the operation of the solidarity surcharge
Capital gains are assumed untaxed at personal level, as seems a reasonable simplification for Germany.
And a further term added to the valuation expression that reflects investment decisions prior to the current period, and so is irrelevant to the optimization.
