Germany's Inheritance Tax Needs Reform

Generating some 4.5 billion euros in revenues each year, Germany's inheritance tax is actually a small source of income for the state – revenues from taxes on tobacco, for example, are more than three times as high. But despite its marginal importance as a source of revenue, the inheritance tax is a hotly debated issue. Proponents of the inheritance tax advocate rate increases, arguing that the taxation of inherited wealth is simply a matter of fairness, as beneficiaries have done nothing to earn the wealth they inherit. By contrast, critics argue that the inheritance tax endangers jobs, as the heirs of family-owned companies face large tax bills that can cripple a company's liquidity.

German policymakers have sought to achieve compromise by preserving a tax rate of up to 50% on inheritances and gifts while creating exceptions that ease the burden on entrepreneurs. Company assets, for example, can be transferred tax-free when the heir does not sell the company and when the average wage bill seven years after the transfer is not lower than the average five years prior. This appears to be a reasonable solution at first glance. A closer examination reveals massive weaknesses, however.

First of all, the exceptions create considerable loopholes for tax avoidance. It is difficult to determine whether assets are an essential part of a company, or were merely transferred to a company by heirs to avoid taxation.

Second, the requirement that a company continue to operate as before without a lower wage bill has negative economic effects, as it makes restructuring impossible. However, particularly after the death of an owner, the restructuring or sale of a company is often required in order to save jobs.

Third, the exceptions created for companies raise questions of fairness. Why should gifts and inheritances that are in some cases extremely large be exempted from taxation while other types of wealth are taxed at a 50per cent rate?

Germany's Federal Tax Court is of the opinion that current inheritance tax rules are incompatible with the principle that all taxpayers should be treated equally. Accordingly, in 2012 the Tax Court asked the Federal Supreme Court to rule on whether the inheritance tax's exemption rules violate the German Constitution. Due to widespread fears that the exemption rules might be abolished, the volume of company assets transferred on an annual basis has increased rapidly in Germany in recent years – from approximately 5 billion euros in 2010 to 26 billion euros in 2012. Of course, the current exemptions mean there was no associated increase in tax revenues.

As the Federal Supreme Court will soon rule on this issue, policymakers should seize the moment and improve the inheritance tax. Simply abolishing the exemptions for companies would not be a good solution, as it would place excessive burdens on companies, thus endangering jobs and growth. A better solution would be to limit the taxation of inheritances and gifts to between 8 and 10 per cent, as well as to grant company assets an eight year deferral period, without red tape. This reform would allow companies to pay inheritance taxes with profits from normal business activities while also eliminating the extreme unfairness and economic disadvantages of the current system.