For more than a decade, growth in Germany has been subdued and uneven. This paper introduces the stylized facts pertaining to the strength in exports, the weakness in domestic demand, and the surge in the current account. It discusses the adjustment undertaken in the private sector and its impact on exports and domestic demand, followed by fiscal and monetary policies and their macroeconomic impact. Finally, structural impediments accelerating capital exports and the rising current account surplus are outlined.


For more than a decade, growth in Germany has been subdued and uneven. This paper introduces the stylized facts pertaining to the strength in exports, the weakness in domestic demand, and the surge in the current account. It discusses the adjustment undertaken in the private sector and its impact on exports and domestic demand, followed by fiscal and monetary policies and their macroeconomic impact. Finally, structural impediments accelerating capital exports and the rising current account surplus are outlined.

III. Business Tax Reform in Germany38

Amid increased competition over mobile capital and profit shifting of corporations to foreign subsidiaries the government intends to reform the corporate tax system. This chapter assesses the likely impact of the cornerstones of the reform. The general direction of the reform—cutting rates and broadening the base—is appropriate. The policy debate has focused primarily on options to reduce profit shifting and to broaden the tax base. The paper examines the pros and cons of some of the key provisions that have been put forward, including limits on the deduction of interest costs in specific cases. It concludes that targeted limits on interest deduction that are akin to thin capitalization rules may be better suited than broad limits to reduce revenue leakage. Eliminating accelerated depreciation allowances and raising business property taxes are promising avenues for broadening the tax base and limiting the revenue loss. The envisaged package of reforms, however, would not reduce the complexity of the business tax system in Germany. The proposal is not yet finalized and hence the judgments in this paper should be viewed as preliminary.

A. Introduction

76. Just five and a half years after the last major corporate income tax (CIT) reform, the government published an outline for further reform intended to become effective in 2008.39 While many details remain open, the plan generally aims at broadening the tax base combined with lowering tax rates. This is in line with previous reforms and those in other advanced countries over past decades.40 However, some of the specifics of the original German proposal were unusual and triggered a second round of proposals.


Top Statutory Corporate Tax Rates: 1995-2005

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A003

77. The need for reform is the result of external pressures and Germany-specific factors. During the last decade, 20 of the now 25 EU members have cut their CIT rate at least once.41 European integration and greater mobility of capital have created common pressures on all advanced economies to cut statutory rates. Moreover, Germany needs to reform business taxation to reduce the complexities of the current system and the unintentional heterogeneity of tax burdens across firms.

78. Limited scope for tax relief requires offsetting measures reducing the targeted incentive effects. Because the fiscal deficit and debt are high, and aging pressures are building, Germany can ill-afford permanent revenue losses. CIT reforms are complicated and the behavioral responses can be difficult to predict. This became clear in the last reform in 2000, when CIT revenues unexpectedly turned negative (in net terms) in the first year following the reform, before they recovered.42

79. The objective of this paper is to assess whether the reform is likely to be effective in lowering distortions in German business taxation. The paper concludes that:

  • The direction of reform, lowering tax rates and broadening the tax base, is appropriate in light of international tax competition pressures.

  • The reform may reduce profit shifting by multinationals operating in Germany to their subsidiaries in lower-tax jurisdictions. The authorities’ most recent proposal includes limits on the deduction of interest costs in specific cases where there is evidence of borrowing from foreign subsidiaries to shift profits abroad. This is a moderation from initial proposals of broad limits on interest and leasing cost deductions, which could have induced unintended distortions in business investment decisions.

  • The corporate tax burden remains high and pressures for additional reform are likely to continue in light of further tax competition from abroad.

  • Even after the reform, the German CIT system would remain complex.

80. The reform plan is not yet final. The latest proposal reflects the outcome of the government’s working group and awaits endorsement by the cabinet. The political challenge is to cut CIT rates at a time of fiscal consolidation and other tax increases, such as the VAT. Moreover, while theory suggests that the final incidence of even a CIT may largely fall on labor (the less-mobile factor), the public perception may nevertheless be that a CIT cut mainly benefits owners of capital and raise additional resistance.

B. The Corporate Income Tax System in Germany

81. Profits are subject to three layers of taxation: a federal corporate income tax, a municipal trade tax, and a solidarity surcharge. The federal tax is charged at a rate of 25 percent. The municipal tax rate is subject to a minimum of 10 percent without a maximum, but in practice the highest rate is 24.5 percent.43 The local tax is a deductible expense from its own tax base and that for the corporate income tax. The solidarity surcharge is 5.5 percent of the federal tax liability. The resulting composite CIT rate ranges from 33.1 to 40.9 percent.44

82. The base is different for local and federal taxes. The local tax base is obtained by making several adjustments to the federal tax base. The main adjustments include: (i) half of all long-term interest expenses are added back in, (ii) half of all rental and lease payments are added back in, unless they are subject to the local tax by the recipient, (iii) any foreign profits are deducted, and (iv) a measure related to the value of real estate is also deductible (as real estate is subject to a different local tax).

83. There are many unincorporated firms whose tax treatment differs from incorporated ones. While they are liable for local trade taxes, at the federal level they are assessed at the personal (PIT) rather than corporate income tax rate. Whether this leads to lower or higher effective taxes depends on the specific circumstances. In very general terms, firms with low profits are better off under the (progressive) PIT system, while those with large retained profits are better off under the CIT system.

84. Taxation at the shareholder level follows a relief system. Only half of the dividend earnings are included in the PIT base, to account for some of the tax already paid at the corporate level (to diminish double taxation). However, interest income is fully taxable under the PIT. Withholding taxes are preliminary and taxpayers whose marginal tax rate is higher than the preliminary assessed rate need to cover the difference, while those below are entitled to a refund. Moreover, there is a personal allowance for capital income of €1,370 (€2,740 for couples) per year.45

85. Thin-capitalization rules limit the amount of debt that can be held by owners or other related parties (Gesellschafter-Fremdfinanzierung). Specifically, lending by each shareholder may not exceed 1.5 times the equity held, otherwise interest is not tax deductible. This measure aims at limiting profit shifting to lower-tax countries through excessive borrowing from other subsidiaries of the same multinational enterprise located in lower-tax countries.

86. Putting the German CIT tax system into a comparative perspective is hampered by the complexity of tax laws. With tax codes in most countries running to hundreds of pages, a full comparison of all rules determining the tax base (e.g. varying definitions of capital, assets, and liabilities; different rules for provisions, acquisition and production costs, depreciation rules and inventory valuation, etc.) is not practicable. Simple measures, such as the effective tax rates used below, do take tax base definitions into account, but necessarily abstract from most of the detailed rules.46 Tax measures based on revenue data reflect all tax rules, but they are a function of company behavior and can be very misleading. Low tax countries for example, where it is profitable to locate businesses and report profits, would tend to have high tax revenues, and it would be wrong to interpret this as evidence of strict tax laws. An international comparison of a variety of tax rules for corporate income tax (CEPS 2005) does not suggest that Germany’s corporate income tax system is an outlier in terms of definitions of its tax base. However, the study focused on ways to achieve tax harmonization within Europe and did not evaluate corporate tax systems. More generally, there is tremendous heterogeneity of tax rules across countries which reflects the absence of a common international best practice standard.

C. Pressures Faced by the German Corporate Income Tax System

Tax competition

87. As an open economy, Germany is subject to fiscal externalities, to the effect that other countries’ tax choices affect German welfare, and vice-versa. These externalities induce competition for the location of (i) productive activity,47 (ii) reported profits, and (iii) corporate headquarters.

  • Location decisions by multinationals depend on a range of factors including average effective tax rates that are determined by a combination of the tax laws, investment allowances, treatment of losses, etc. In general, the more profitable an investment, the more important is the statutory tax rate, as this is the marginal rate applicable to an additional unit of profit, while most allowances relate to costs.

  • Profit reporting depends mostly on statutory tax rates, which determine the tax saving from profit shifting. It is limited by rules against profit shifting, such as transfer pricing and/or thin-capitalization rules.

  • The location of corporate headquarters depends mainly on the treatment of foreign-source income. Countries that exempt such income are generally more attractive than those that just provide a credit for foreign taxes.48

88. Tax competition may have intensified with the EU accession of Eastern European countries that have low statutory tax rates. In 2005, following the accession of 10 new member countries, top statutory tax rates averaged 30.0 percent in the old member states, and only 20.6 percent in the new member countries. At this time, some old member states cut their CIT tax rates, notably Austria, which also shares a land border with the new members states. If for the comparison definitions of tax bases are also taken into account, Germany’s average effective tax rate remains high by international standards.


Average Effective Tax Rate: Devereux Griffith (2005)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A003

89. The debate about the economic implications of international tax competition has not yet reached a consensus on where the process will end.49 There are however theoretical arguments that suggest that Germany, as a relatively large economy, could have somewhat higher tax rates than some of its neighbors.50 Also, countries which are close to large markets (and/or have large internal markets) should be able to maintain a higher tax rate than smaller countries at the periphery because they can tax agglomeration rents (Baldwin and Krugman, 2003).

90. The empirical literature shows that statutory tax rates have come down over the last three decades, tax bases have been broadened, and corporate income tax revenues have remained relatively stable.51 Explanations for these trends include competition for highly profitable activities or for reported profits,52 but it could also be the result of an emerging consensus about the benefits of low statutory tax rates.53

91. There are important links between the location of productive activity and profit shifting. If profit shifting enables firms to avoid tax, then high tax rates are less distortionary in effective terms and may not displace much investment. Consequently, a revenue-neutral reform that reduces the scope for profit shifting, but cuts tax rates may not attract much additional investment, although reported taxable profits would increase.54 To attract more investment, it would be necessary to cut average tax rates, at least for highly profitable, mobile firms.

EU Implications

92. The rules on tax competition and evasion are increasingly affected by judgments in the European Court of Justice. As a result, it is more difficult to react to profit shifting, as tax laws cannot treat transactions with other member states (where profit shifting is possible) differently from domestic ones. Moreover there are revenue risks to the extent that existing laws may be found to be in breach of EU law.

Domestic Issues

93. Germany, like some other countries, allows tax competition between municipalities.55 Under the new proposal tax competition at the local level may intensify, as lower federal rates reduce the benefit of deductibility and hence increase the net impact of local taxes. While there is no consensus in the economic literature on whether tax competition is harmful, beneficial, or irrelevant,56 it would be difficult to justify different judgments about the merits of domestic and international tax competition.

94. Effective tax rates vary across different investments. For instance, some types of assets benefit from favorable depreciation treatment. Also, debt-financed investment often incur lower taxes (common in most countries).

D. Reform Proposals

95. Based on the cornerstones for reform (Eckpunkte) published in July 2006 (Box 1) a working group was commissioned to prepare a final business tax reform plan. After intensive public debate and negotiations the group reached an agreement in November 2006.

Main Features of the Original Proposal from July 2006

  • The federal CIT and local trade tax is to be renamed to federal and local business tax.

  • The composite tax rate is to be cut by about 10 percentage points to just below 30 percent. The distribution between the federal and local tax is yet to be determined.

  • The bases of the local and federal tax are to be harmonized.

  • The tax base is to be broadened to partly offset revenue losses. One element would be to limit the deductibility of some interest expenditures and leasing costs. Different mechanisms are to be considered: (i) the deductibility could be limited to a fixed percentage (as is already the case for the local tax), (ii) there could be a maximum tax deductibility or a minimum tax rule, or (iii) interest deductibility could be removed for loans from owners or related parties.57 Other financing options are also to be considered, such as the taxation of a company’s real estate or payroll.

  • For the PIT, capital income (both dividends and interest) is to become subject to a final withholding tax. Proposed rates range from 25 to 30 percent.

  • For businesses under the PIT rather than CIT, the rate for retained earnings may be reduced or tax deductible provisions for investment may be introduced.

  • The inheritance tax is to be eliminated for heirs who continue running the family business, subject to certain conditions such as job preservation.

  • The overall revenue cost of the reform should not exceed €5 billion (¼ percent of GDP) per year.

96. Many of the key elements of the reform announced in July remain valid. The proposal confirms the intention of a significant corporate income tax cut, which would be partly financed by tax base broadening. Targeted revenue losses are still intended to be limited to 5 billion euros (0.25 percent of GDP).

97. The main changes in the November version compared to the July proposal relate to the tax base broadening measures and new or tighter rules for preventing profit shifting.

  • The government will introduce a revised rule for limiting the deductibility of interest expenses. Instead of including 50 percent of interest payments in the tax base, interest will remain deductible subject to an upper limit linked either to profits or equity and coupled with a general exemption of 1 million euros per year. The law would also include an escape clause for special business circumstances.

  • The tax base of the local trade tax and the corporate income tax will not be harmonized. The local trade tax will include 25 percent of interest and leasing expenditure rather than 50 percent of interest expenditure as now.

  • The tax base will be broadened by eliminating accelerated depreciation rates.

  • The income tax rate on retained earnings of businesses under the PIT will be lowered to 29 percent to approximately match the corporate income tax rate. This measures clarifies the planned tax relief for smaller enterprises.

  • Several measures aimed at preventing profit shifting are considered: a tightening of rules to avoid shifting profitable functions of multinational corporations to low tax countries in line with international conventions on transfer pricing; new limits on the ability of recognizing losses in cases of mergers and acquisitions.

98. These changes address important concerns raised in the public debate. The original plan for a CIT reform included a controversial provision to limit interest deductibility for all corporations. The staff and others had raised concerns about too sweeping a restriction on interest deductibility as explained in the following subsection. The revised proposal would restrict interest deductibility to a limited number of cases.

99. However, a final judgment on the reform needs to be postponed until a complete draft is released. The implications of the new provisions cannot be easily quantified, because they are not final and because quantification would require detailed knowledge about the structure of corporations in Germany.

Implications of a General Limitation of Interest Deductibility

100. To judge the net effect of any reform on firms’ incentives, it is useful to summarize the tax burden into a single measure, such as the cost of capital or an effective marginal or average tax rate. To that end, some specific assumptions were made, including that (i) the federal rate will be cut in half, with local rates remaining unchanged and;58 (ii) that the tax base will be broadened by including 50 percent of interest expenditures. The latter assumption reflects the most stringent version of deductibility limitations which were originally under consideration.

101. An expansion of the tax base by discontinuing full interest deductibility would have been atypical but not without justification. While unusual in practice, taxation of interest at the corporate level has a theoretical background and justification. A corporate tax with no deduction of interest is known as a Comprehensive Business Income Tax (CBIT), and was first suggested by the US Department of Treasury (1992), as a method to reduce the distortion that results from different tax treatment of equity versus debt financing (currently, in most countries, generating a preference for debt financing). It is one of the recurring proposals for fundamental tax reform, with the main alternative being an Allowance for Corporate Equity system, which instead permits firms to deduct notional interest costs on their equity stock. 59 The original reform would thus achieve a system with aspects of a CBIT, and thus reduce, but not eliminate the tax-preference for debt finance. Moreover, it could have potentially led to further difficulties: (i) if interest is only partially deductible, it would also be necessary to exempt part of interest received by other corporations to avoid cascading of taxes; (ii) it could create complications with double tax agreements, which were drafted on the assumption that interest is fully deductible from the federal tax; (iii) it would appear inconsistent with European initiatives to harmonize tax bases.

102. For now, we abstract from the taxation at the personal level, such as taxes that are paid on dividends and interest. This will allow to single out the effect on taxes at the corporate level. More importantly though, this is also the preferable way of analyzing the incentives faced by companies in an open economy whose shareholders and debtors may be nonresidents and, therefore, not liable to German personal income taxes.60 Such flows may face taxes in the investor’s home country, but those would be different depending on the country and can potentially be avoided. The assumption that the marginal shareholder faces no capital income taxation is made often in the literature.61

103. The effective average tax rate (EATR) reflects the hypothetical impact on the tax base and rate in a single measure. This concept was developed in Devereux and Griffith (2003) and is summarized in Appendix A. It is defined for different levels of expected economic profit (p), allowing an impact analysis varying with the profitability of the business.

104. The EATR encompasses the earlier concept of the effective marginal tax rate (EMTR) as a special case, which is obtained when the expected after-tax profit is zero. As argued in Devereux and Griffith (1998), the EMTR may be informative about investment incentives at the margin, but will be less relevant for discrete investment decisions of multinationals which expect to earn economic profits. If personal income taxes are ignored, the EATR turns out to be the weighted average of the EMTR and the statutory tax rate. The higher the expected after-tax profit, the closer is the EATR to the statutory rate. If personal income taxes are included—which they are not for now—it will be necessary to distinguish between finance by retained earnings and new equity because dividends are taxed differently from capital gains. Moreover, the EATR will then converge towards an adjusted statutory tax rate that takes personal taxes into account.62

105. Based on the EATR, analysis shows that limiting interest deductibility would have had the following effects:

  • The tax burden for all equity-financed investments would have been reduced. The cut in the statutory tax rate shifts the entire tax schedule down by about 10 percentage points (Figure 1), as equity-financed firms are not affected by the reduced interest deductibility. The pattern of the EATR remains largely unchanged, with the EATR rising as profitability rises.

  • For debt-financed investments the tax burden would have only declined for highly profitable firms. The importance of the lower statutory tax rates, envisaged under the reforms, rises with firms’ expected profitability. At the same time, the lower interest rate deductibility affects relatively less profitable firms the most. As a result, the effective tax schedule becomes flatter and the pre- and post-reform schedules cross (at 16 percent profitability), given the assumptions. In summary, firms relying on debt-finance would also experience an effective tax cut, if profits are sufficiently high.

  • The tax treatment of debt-financed firms would have remained more favorable than that of equity-financed firms. The EATR schedule for debt-financed firms remains below the EATR schedule for equity-financed projects. While the preferential treatment for debt finance would be reduced, it would not be eliminated by this reform.

Figure 1.
Figure 1.

Germany: The Effective Average Tax Rate for Equity and Debt-Financing

(In percent)

Citation: IMF Staff Country Reports 2006, 436; 10.5089/9781451810523.002.A003

Source: Author’s calculation. The statutory rate includes all layers of taxation (see appendix).

106. Based on the EMTR, tax rates would have been lower under for equity-financed investments and higher for debt-financed investments. Equity-financed investments benefit from the lower tax rate and are unaffected by the changes to taxation of interest. Debt-financed investments become less attractive because the rate cut has a smaller effect on a marginal project than the increased tax burden on interest.63

EMTR and Cost of Capital with and without Limits on Interest Deductibility

(In percent)

article image
Source: Staff calculation.Notes: For definitions see Devereux and Griffith (2003). Assumptions discussed in the appendix.

107. A general limitation of interest deductibility may have been successful in reducing profit shifting, but it is less clear whether it would have attracted much new investment. The reduction in profit shifting is achieved directly by broadening the tax base to include interest and, indirectly, by lowering the statutory tax rate, which reduces the benefit from profit shifting. For an investor using equity finance, or expecting high profits under debt-finance, Germany would have become more attractive to locate business activity. However, for an investor expecting low profits and planning to use debt finance, or used to avoiding most of the tax by profit shifting, the effective tax rate may have increased and could have potentially led to a shift of production abroad.

Changes to the taxation of capital income

108. The introduction of a final withholding tax on dividends and interest will increase dividend taxation but reduce interest taxation for a top-rate taxpayer. This is because the proposed final withholding tax of 25 percent is lower than the current top rate of the PIT schedule, but still larger than half that rate, which is implied by the half-income system. Changes at the individual level, therefore, work in the opposite direction of those at the corporate level. Hence, when individual taxes are taken into account, changes in EATRs are much smaller across all sources of finance, although EMTRs increase quite significantly. It should be remembered though that the marginal providers of funds may not be liable to German PIT, so that it is questionable whether tax changes at the individual level affect firms’ cost of capital.

Effective Average Tax Rates, Including Taxes at the Individual Level

(In percent)

article image
Source: Staff calculation.

Changes affecting small businesses

109. The tax reform for small companies which are under the PIT system generates some questions. The possible reintroduction of a split rate system (i.e. a lower rate for retained earnings) is surprising given that, for firms under CIT, this was just abolished in the 2000 reform. More generally, it is not obvious why retained earnings should be preferred to other sources of finance, although it is true that this is also the case for large firms, if personal taxes are taken into account. If the aim is to allow small firms to share the benefit of lower tax rates on retained earnings, it would be worth reducing the cost of incorporation, instead.

110. Reducing inheritance taxes on heirs who run the family business and avoid job losses also raises some questions.64 First, why should preference be given to heirs running companies over outside investors.65 Also, why should the tax system create incentives to keep firms in sole ownership, rather than as public corporations with shares subject to inheritance tax. Moreover, the anticipated restriction on job losses may lead to inefficient staffing. Ensuring compliance with these provisions is, in any event, difficult, particularly if the restriction on job losses covers a long period. In sum, the proposed changes to the inheritance tax may increase distortions, rather than lower them.

E. Further Reform Considerations

111. International pressure cannot easily be dealt with at the national level. If tax competition is considered harmful, than a supranational solution is required. The European Commission is proposing to harmonize corporate tax bases, which could later lead to a common consolidated tax base for the EU, to be allocated to member states by an apportionment formula.66 The suggested reform should therefore be carefully reviewed to not preclude a possible later move towards tax harmonization.

112. Increasing taxation of business real estate would shift some of the burden of taxation towards the owners of the immobile factor land. It may therefore be an appropriate response to tax competition. Moreover, taxes on immovable property are comparatively low in Germany.67

113. A competitive tax rate is a dynamic concept. As long as other countries keep changing their tax rates, further reductions may be required to keep the same position. Other countries could decide to react to the German rate cut by adjusting their rates too.

114. There remains ample scope for simplification. The alignment of tax bases would remove one obstacle to replacing the local and federal tax and the solidarity surcharge with a single business tax—however, the problem of different local tax rates would remain. Yet, if tax competition across countries is a problem, why should it be considered an advantage within Germany?

115. Despite these pressures for continued reform, the importance of a stable tax system should not be forgotten. Long-term investments are discouraged by frequent changes to tax laws. This concern should not prevent reform, but calls for a well-designed reform and good implementation, so that the risk of the need for corrections is minimized.

F. Conclusions

116. The current corporate income tax system in Germany faces multiple pressures, and the case for reform is strong. It is important that the reform is well-designed and implemented to reduce the risk of backtracking or the need to introduce quickly another round of reforms to correct them.

117. The general direction of the reform is to broaden tax bases and cut tax rates, which is in line with recent reforms elsewhere. It can be seen both as a response to profit shifting and competition for profitable investments and should help alleviate these pressures.

118. The November proposal for limited interest deductibility appears less controversial than earlier plans. The latest proposal is a moderation from initial proposals of broad limits on interest and leasing cost deductions, which could have induced unintended distortions in business investment decisions and may have been inconsistent with existing double tax agreements as well as European tax harmonization initiatives. The implications of the new provisions cannot be easily quantified, because some key provisions are still undecided and because quantification requires a detailed knowledge about the structure of corporations in Germany. Nonetheless, some general observation can be made. First, the high exemption rate would reduce the likelihood of creating a higher tax burden for less profitable, bank-financed enterprises compared to the previously proposed rule. Second, the new rule would generate less international tax complexities compared to earlier plans, since it is targeted at a small number of large enterprises and, depending on the final formulation, possibly more in line with standard thin capitalization rules.

119. The suggested reform of the CIT is likely to achieve some, but not all its aims:

  • Profit shifting is likely to be reduced because the targeted taxation of interest will make it more difficult to shrink the tax base for large enterprises, while a lower statutory rate will reduce incentives to do so.

  • Harmonization. Tax bases of local and federal business income tax will not be fully aligned.

  • Complexity. The reform will not reduce the complexity of the business taxation system.

120. New tax base broadening measures should help limit revenue losses. The government plans to eliminate accelerated depreciation provisions, which are likely to exceed true economic depreciation.68 This is a welcome step. However alternative tax base broadening measures, such as raising business property taxes, could also be considered to limit the risk of larger than expected revenue losses if profit shifting cannot be prevented to the intended extent. The suggested taxation of firms’ real estate would be a particularly well-targeted response to tax competition, because of the shift towards an immobile factor.

121. The reform proposals for small businesses raises some questions. The abolition of inheritance tax for small businesses is difficult to justify.

122. Even if a well-designed reform takes place, further reforms may be necessary depending on developments in other countries.

123. A final judgment on the reform needs to be postponed until a complete draft is released. The revised proposal from November 2007 by the working group still requires cabinet approval. Further decisions on details need to be taken to translate the reforms into draft legislation. Under current plans legislative changes will be submitted to parliament in early or mid 2007. Full implementation is planned for January 2008.

Appendix A. Effective Average Tax Rate

The effective tax rates were calculated according to the methodology developed by Devereux and Griffith (2003). The effective average tax rate, or EATR is defined as: EATR=R*Rp(1+r), where R* is the rent earned without tax, R is post tax rent (defined below), p the real financial return and r is the real interest rate. For an investment, which just breaks even after tax (i.e. R = 0), the EATR is equal to the effective marginal tax rate, EMTR.

The rent of a project can be modeled as a perturbation in the value of the firm, defined as R=s=0γdDt+sdNt+s(1+ρ)s, where Dt+s are dividends, Nt+s are new equity issues at time t+s; y is a term measuring the discrimination between new equity and distributions, defined as γ = (1−td)/(1−z), where td is the tax rate on distributions and z is capital gains tax rate; and ρ is the discount rate, defined as (1−ti)i, where i is the nominal interest rate and ti is the tax rate on interest.

Devereux and Griffith use this framework to analyze the tax consequences of a one period perturbation in the capital stock, financed by retained earnings, debt or new equity. This investment is modeled as an increase in capital stock by 1, yielding a real financial return of ρ, and being subject to real economic depreciation of δ The tax system provides an investment allowance of φ and taxes profits at rate τ. For convenience, the above equation is solved for retained earnings first, yielding a level of rent RRE. The cases of finance by new equity and debt are then dealt with by additional financial effects for new equity FNE and debt FD, which are calculated as: FNE=ρ(1γ)1+ρ(1ϕτ) and FD=γ(1ϕτ)1+ρ(ρi(1τ)).

This paper extends the Devereux and Griffith (2003) framework to allow the calculation of effective tax rates under limited deductibility of interest. This is achieved by changing the financial effect of debt finance to FD=γ(1ϕτ)1+ρ(ρi(112τ)).

The following specific assumptions were made to allow the calculation of tax rates: Economic depreciation (δ): 12.25 percent

Writing down allowances (φ): 20 percent per year declining-balance for four years, then 10 percent per year straight line until fully written down.

Local tax rate: 22.5 percent (i.e. “Hebesatz” of 450 percent).

Inflation (π): 2 percent.

Real interest rate (r): 5 percent (including risk premium).


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  • Weiner, Joann (2002) Formulary Apportionment and the Future of Company Taxation in the European Union, CESifo Forum 1/2002, pp. 10 –20.

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  • Wilson, John D. (1999) Theories of Tax Competition, National Tax Journal 52, 269 –304.


Prepared by Alexander Klemm (FAD) and Stephan Danninger (EUR).


On July 12, 2006, the Ministry of Finance published a list of cornerstones (Eckpunkte) of a business tax reform, available at the Ministry of Finance’s website: A revised proposal was announced by a working group in November 2, 2007 and its details are discussed in Appendix A. For an analysis of the 2000 reform see Keen (2002).


See inter alia Devereux et al. (2002).


The exceptions being Malta, Norway, Slovenia, Spain and Sweden. Source: Updates from Devereux et al. (2002) (from and KPMG Corporate Tax Rate Survey (various years).


The unexpected revenue losses were the result of the abolition of the previous split rate system, in which tax rates on distributions were lower than on retentions, and companies were allowed to reclaim the difference between both rates when they distributed previously retained profits. The reform introduced a uniform rate (below both previous rates), but still permitted firms to reclaim the tax differential when paying out previously retained profits. This created an incentive for firms to make distributions out of retained earnings to benefit from the tax rebate, while new profits could be retained without being subject to a higher tax rate. This accelerated pay out of retentions led to (temporary) negative overall tax payments.


Formally, the law provides for a statutory rate (Steuermesszahl) of 5 percent, which is augmented by a municipal multiplier (Hebesatz) between 200 and 490 percent.


This is calculated as 1+f(1+s)1+l , where l: local tax, f: federal tax and s: solidarity surcharge.


To be reduced, as already legislated, to €750 (€1,500 for couples) from 2007.


Reassuringly though, attempts to incorporate more tax rules, such as in the European Tax Analyzer model do not change rankings obtained by effective tax rates much. See Spengel and Wiegard (2005).


For recent evidence on the effect of taxes on FDI into Germany see Becker et al. (2006).


Headquarters located in countries that provide a credit for foreign taxes face additional tax charges on profits originating in countries whose taxes are lower than in the residence country. In practice such residence taxes can often be avoided, for example by mixing profits from low and high tax foreign jurisdictions.


This literature is surveyed in Wilson (1999), and Fuest et al. (2003).


Because a large economy loses more revenue from lowering the tax rate on its existing capital stock, while gaining little new capital in proportion to the existing capital (Bucovetsky, 1991).


This applies to advanced economies (Devereux, Griffith and Klemm, 2002). For developing countries there is some evidence that tax-to-GDP ratios have fallen somewhat as tax rates were reduced (Keen and Simone, 2004).


For a theoretical treatment of the incentives to broaden tax bases and cut tax rates to attract reported profits see Haufler and Schjelderup (2000).


There is a small empirical literature on how countries react to tax changes in other countries, surveyed in Brueckner (2003). At least for some taxes, there appears to be a behavioral response by tax authorities, rather than a common trend in tax policy. It is not possible though to distinguish between tax mimicking and a reaction based on resource flows.


For instance, a lower tax rate may generate profits in addition to those that would not be shifted anymore.


For empirical evidence see Buettner (2001).


The following provides one example for each case: tax competition will be harmful if it reduces the taxing capacity of a welfare-maximizing government; it is irrelevant if there are other taxes that can be raised at the same cost instead; and it can be beneficial if governments are over-taxing for political economy reasons.


The banking sector would be exempted from changes in interest deductibility.


The 12.5 pp cut in the federal tax rate leads to a reduction in the cost of the solidarity surcharge and also reduces the deductibility benefit of the local tax; in net terms, the composite tax rate drops by 10 pp.


The main references are Boadway and Bruce (1984) for the theoretical foundations, and Devereux and Freeman (1991) for a discussion of a practical proposal.


Or liable only to a very limited extent if double taxation treaty provides for a withholding tax.


This “tax irrelevance view” was first stated in Miller and Scholes (1978).


Even though more taxes will be included, tax rates can decrease, because the required rate of return for shareholders is reduced by the taxation of interest.


Indeed, it is worth noting that the EMTR under debt-finance is negative under the current tax legislation. This outcome results from combining interest deductibility and investment allowances. The former already would ensure that normal profits would not be taxed, as they would just cover the interest paid. Additionally allowing firms to deduct depreciation allowances implies that the tax system is subsidizing some investment (assuming the firm has taxable profits to apply the deductions). It would be sufficient to have some expectation of future profits, as tax losses can be carried forward, although they will be less valuable because of lost interest.


This measure was approved by the cabinet on October 25, 2006.


Recent empirical evidence suggests that poor management practices are prevalent among family-owned firms which pass management to their eldest son (Bloom and Van Reenen, 2006).


The apportioned tax base could then be taxed in each country at the national tax rate. This would remove intra-EU profit shifting opportunities, but not necessarily tax competition, as companies could still move the factors of the apportionment formula to benefit from low tax rates. For an overview of the issues see inter alia Klemm (2001) or Weiner (2002). The policy was established in European Commission (2001) and its progress reviewed in European Commission (2006).


According to OECD Revenue Statistics (2006), taxes on immoveable property raised 0.4 percent of GDP in Germany, compared to 0.9 percent for the OECD average, 0.8 percent for the EU15 average and 2.8 percent in the United States in 2004.


Currently moveable investment goods can be depreciated at double rates using the declining balance method, until this leads to lower depreciation than the straight-line rate.

Germany: Selected Issues
Author: International Monetary Fund