Key Objectives of German Tax Reform at Risk

The intended tax reform by the government falls short of the mark. The government in Berlin intends the reform to strengthen the competitiveness of German businesses as well as the attractiveness of Germany as a business location for national and international investors. According to calculations carried out by the Centre for European Economic Research (ZEW) and the University of Mannheim, however, the tax relief, although it improves companies’ competitiveness, is too small. Capital-intensive and profit-distributing businesses in particular, hardly benefit from the tax relief. Furthermore, the planned reform causes new distortions and demarcation problems, making the German tax system even more complicated than it already is. Furthermore, the dependence on the legal form of the company taxation is criticised. It was intended to cushion the dependence but instead, it has reinforced it by the introduction of a corporate tax system applicable for Europe, namely the half-income method. The result creates new problems. All in all, we should ask if the tax reduction law in its current form can actually achieve its central goals.

According to the ZEW tax experts, promoting Germany as a business location and as a relief site for companies is possible without further complicating the tax system or inducing tax distortions. This, however, requires a considerable reduction of the tax rate and a harmonisation of the top income tax rate with the corporation tax rate. In this context, the planned implementation of the half-income assessment method should once again be reconsidered.

Winners and losers of the reform

The ZEW analysis reveals the advantages and disadvantages of the individual measures of the tax reform. Since it improves the competitiveness of German-based companies, the tax relief is positive. A negative effect, however, is that this maintains the existing trade tax burden.

General forecasts on the extent and burden of the tax on a corporation level are not possible. Calculations by the "European Tax Analyser" software programme, however, show that the extent of the company`s relief largely depends on the dividend policy as well as on its investment intensity. Thus, companies retaining a greater proportion of their profits are winners in light of this reform;  the tax rate on retained profits is reduced by 15 per cent (from 40 to 25 per cent), while the tax rate on distributed profits (from 30 to 25 per cent) is reduced by only five percentage points.

Investment-intensive companies, however, are losers in view of the counter-financing measure. This is due in particular to the deteriorated conditions for depreciation allowances; the measure decreases income and corporation tax by broadening the tax base. Since counter-financing has clear detrimental effects on machine and building investments, it is questionable whether the tax changes will really increase the investment activity in Germany.

The overall tax burden of SMEs, which alongside the taxes of the company also includes taxes paid by the shareholder (on profit distributions), is also reduced. In contrast, shareholders of large firms are likely to bear a higher burden than before. This is a result of the changeover from the corporate income tax full imputation system, to the half-income method; in the future, the corporate tax on dividends will always be definitive.

Furthermore, serious distortions regarding entrepreneurial decisions result from the introduction of the half-income method. The general rule is that in the future, the question of whether corporations should be financed by equity, or rather by shareholder loans, depends on the personal income tax rate of the shareholder.

 In the case of low personal income tax rates, shareholder loans prove to be the better financing option. Equity financing, however, is the better option, where the personal income tax rates are high.

 Similar distortions and demarcation problems arise in regard to the question of whether shareholders should receive corporate profits through dividends or shareholder agreements (e.g. salaries).

Ambiguous incentives for domestic and foreign investors

International comparison shows that after the reform, the tax burden on companies in Germany will be smaller than that in the US and in France. It will still, however, be considerably higher than in the Netherlands and in the UK. The improvement of Germany's competitiveness in the international tax competition ought to have a positive impact on the investment and location decisions made by international investors. However, this positive effect is countered by other planned measures.

The former discriminatory tax treatment of distributed profits from (subsidiary) companies in the corporation tax credit system, for example, is now dropped due to the introduction of the half-income method. The attractiveness of foreign investment is thereby increased for German companies. From the point of view of foreign investors, Germany's attractiveness as a business location is also reduced. Since the tax on dividends is of relative importance for foreign investors, the reduction in tariffs from 30 to 25 per cent tends to be insufficient given the added deteriorated conditions for depreciation. Furthermore, the framework conditions for corporate financing with debt capital worsen due to tightened requirements for the approval of shareholder loan financing.

Taxation respective of legal form is reinforced

A further aim which the reform has failed to achieve is the reduction of disparities between corporations and joint partnerships in terms of taxation. On the contrary, taxation respective of legal form will be considerably reinforced and concretised by the implementation of the half-income method and by the even greater divergence between the corporation tax rate and the top income tax rate. The overall tax burden of joint partnerships and corporations will be on the same level only where the shareholders of joint partnerships are liable to pay the top income tax rate and where profits are fully distributed.

Given that it results in a number of disadvantages, paying corporation tax is an option only for a small minority of joint partnerships. On the one hand, for example, the obligation to opt for taxation in a uniform manner could lead to a conflict of interests where shareholders are subject to different personal income tax rates. On the other hand, this option results in major drawbacks in terms of inheritance tax; this is particularly the case for companies, for which this option is worth considering in the first place. Standard taxation will therefore apply to the majority of joint partnerships. In order to reduce the disadvantages for joint partnerships which are subject to standard taxation in relation to non-distributing corporations, it is advisable to lower the top rate of income tax.

If corporations are subject to a higher tax burden than joint partnerships, which is the case where there are high pay-out ratios and low income tax rates for shareholders, a reduction of the income tax alone, irrespective of legal form, does not suffice to ensure taxation. Rather, it is necessary to include corporation gains in the income tax via an alternative method than that of the half-income method. The advantage of the existing tax full imputation system is that it is likely to create fewer distortions than the half-income method. This is particularly true in the case that a successful harmonisation of the top income tax rate and the corporation tax rate is achieved.

Half-income assessment method creates new problems concerning European law

Given that corporation taxes on foreign gains may not be charged against the German income tax, the current corporation tax system discriminates against foreign gains. The half-income assessment method prevents this inequality by treating national and foreign dividends equally and by deeming only 50 per cent of the dividend taxable income. The implementation of the half-income assessment method thus constitutes a corporate tax system in accordance with EU requirements. However, it is also possible to make the imputation system both tenable under European law and sufficiently compliant with EU requirements. This is of particular importance in view of the fact that the introduction of the half-income method results in new regulations, which are in turn non-compliant with European law. This essentially involves the limitation of foreign withholding tax allowances, controlled foreign corporation rules as well as the approval of corporate debt financing by foreign shareholders.

Contact

Dr. Christoph Spengel (University of Mannheim), Phone: +49(0)621/181-1701 

Dr. Gerd Gutekunst , E-mail: gutekunst@zew.de  

Rico A. Hermann, E-mail: hermann@zew.de  

Dr. Thorsten Stetter, E-mail: stetter@zew.de