The Cost of Capital in the European Union - Fiscal Investment Climate in Germany Significantly Improved

Germany has seen the strongest decline in cost of capital among all 28 EU Member States over the past 15 years, from 7.7 per cent in 2000 to 6.5 per cent in 2014. In an EU-wide comparison of company taxation only, Germany has gained ground, climbing from rank 27 in 2000 to the 24th position. The comprehensive corporate tax reforms enacted in 2001 and 2008 as well as the resulting reduction of the corporate tax rate to 15 per cent have thus proven effective, as shown in a survey by the Centre for European Economic Research (ZEW), Mannheim. However, real and financial investments still have not reached an equal footing.

Germany as a business location substantially depends on private investment to secure employment, create new jobs and strengthen economic growth. By improving fiscal investment conditions, the government can provide incentives for corporate investment activities. The tax burden on investments, however, does not only depend on the nominal tax rate, but also on other fiscal regulations such as depreciation rules.

The cost of capital allows us to comprehensively model the effective tax burden. The cost of capital is defined as the minimum pre-tax real rate of return required by the investor, given a post-tax real rate of return from an alternative capital market investment. Capital costs above the market interest rate signal that real investments are at a fiscal disadvantage compared with financial investments, and that investment decisions are distorted in favour of capital market investment.

The ZEW study defines five kinds of assets (industrial buildings, patents, machinery, financial assets, inventory) and three financing methods (retained earnings, new equity, external debt). The market interest rate is assumed to be five per cent. Based on these factors, the ZEW calculations show that in all EU Member States, the cost of capital for real investments, which are financed through retained earnings, new equity, and external debt, are higher than the capital market interest rates. The study found the lowest costs of capital in Estonia (5.2 per cent) and Bulgaria (5.3 per cent), closely followed by Italy, Belgium and Croatia (5.4 per cent each). The highest costs of capital were observed in Germany (6.5 per cent), Great Britain (6.7 per cent), Malta (6.8 per cent), Spain (7.6 per cent) and France (7.8 per cent). Higher costs of capital are associated with the least favourable tax incentives for investment.

Against this backdrop, specific measures for further reducing the cost of capital in Germany would be to lower profit tax rates or set up more generous depreciation rules, for example by reintroducing declining-balance or accelerated depreciation. However, these measures would just partly meet the investment neutrality requirements of the tax system, which are essential in the debate about fiscal policy.

To improve the investment neutrality of the German tax system, i. e. the equal treatment of real and financial investments, ZEW Research Associate and professor at the University of Mannheim, Christoph Spengel, suggests: "The exemption of retained profits from corporate income tax in Estonia constitutes one example of a corporate income tax that is neutral with respect to the volume of investment. An alternative approach is to allow corporations to deduct notional interest expenses for equity capital from the corporate income tax base, as is the case in Belgium and Italy."

Taking into account the shareholder level, we also have to consider the final withholding tax (Abgeltungsteuer). By exempting dividends and capital gains from the final withholding tax while increasing the final withholding tax rate to the level applicable to corporate profits, i. e. to approximately 30 per cent (dependant on the local profit tax), real investment would get a fiscal advantage over financial investment in the tax system.

For more information please contact

Prof. Christoph Spengel, Phone +49(0)621/1235-142, E-mail spengel@zew.de

Julia Braun PhD, Phone +49(0)621/1235-347, E-mail julia.braun@zew.de