Tax Reform Package 2000 to Bring Sustained Tax Relief

On December 21st, 1999, the German government tabled the key proposals for their "Tax Reform Package 2000". Accordingly, the aim is to create additional incentives for investors and thus to shore Germany's international competitive position. At the heart of the package is a proposal to cut corporate taxes on retained profits from 40 per cent and on distributed profits from 30 per cent to the uniform rate of 25 per cent with effect from January 1st, 2001. The dividend imputation system will be abolished and replaced by a so-called half-income assessment method, according to which only 50 per cent of the dividend will be deemed taxable income in order to reduce the effect of double taxation from income and corporate income tax. The reciprocal financing measures include a reduction of degressive depreciation rates for movable assets (e.g. machines) from 30 to 20 per cent and for immovables from four to three per cent.

The Centre for European Economic Research (ZEW) calculated the consequences of the tax reform for an average company in the manufacturing industry by using the European Tax Analyzer, a simulation programme jointly developed by ZEW and the University of Mannheim. According to the calculations, the company experiences a tax relief of 6.9 per cent from 22.1 million marks to about 20.5 million marks. A precise analysis shows that nearly half of the tax relief resulting from the reduction of the corporate tax rate of 2.7 million marks is curtailed by the less favourable depreciation regulations (increase of tax burden by 1.2 million marks). The degree of tax relief is thus at the bottom of the scale presented by the Federal Ministry of Finance. The Federal Ministry of Finance expects a tax relief of 5.7 to 21.7 per cent, depending on the companies' dividend policy; contrary to ZEW calculations, however, it considers the broadening of the tax base merely in terms of a general supplement.

On an international comparison, the implementation of the planned measures will harmonise the tax burden with those of other major economies. The tax burden of the German company considered here would be approximately 2.5 per cent below the US level and nearly 19 per cent below the French level. However, with the tax reform in effect, the tax burden for the German company would be still about 19.6 per cent higher than for a Dutch company and even 32.3 per cent higher than for a comparable British company. Despite the persisting differences to Great Britain and the Netherlands regarding the tax burden, the reform brings about some significant and necessary improvements for Germany's competitive position. It should be pointed out, however, that the tax reform measures planned in the other countries remained unconsidered in the calculations due to the lack of concrete knowledge about their design. From a German point of view, the calculated effect therefore tends to be overestimated.

On the whole, the effects are generally positive on the corporate level. However, the original objective of the Brühl Tax Reform Commission to limit the tax burden for German businesses to a maximum of 35 per cent could not be fully met. The nominal tax burden from trade tax and income/corporation tax (including the solidarity surcharge) on business profits amount to about 38.6 per cent. It thus falls below the critical mark of 40 per cent. In a ranking of the EU member states, Germany moves up from the last position (position 15) to position 11, and now occupies a middle ranking with the EU average being 35.4 per cent.

When assessing the tax reform regarding its aim to achieve a tax relief for SMEs, one has to consider not only the corporate level but also the shareholder level. Taking into consideration the corporate and shareholder level, the calculations performed with the aid of the European Tax Analyzer for a period of ten years show a reduction in the overall tax burden by almost 3.5 million marks to 26.6 million marks. This decrease is partly due to an early implementation of a measure, which had been originally scheduled for 2002, to reduce the individual income tax rates and partly due to the avoidance of a double taxation on distributed profits as a result of the half-income assessment method. When the half-income assessment method is applied, however, such a tax relief effect can only be achieved if the (marginal) personal income tax rate is higher than 40 per cent, as it was the case in the ZEW calculations. A personal income tax rate of less than 40 per cent would result in an additional tax burden when compared to the previous dividend imputation system. This is due to the fact that in the new model, the definitive burden of corporation tax plus half the income tax on the dividends up to this tax rate is higher than the exclusive taxation of dividends with income tax in the previous dividend imputation system. When the income tax rate exceeds 40 per cent, the results are turned around.

In an international comparison the competitive position of Germany has improved on a general level, if the same figures are taken as a reference. Germany moved up two places and now ranks second behind Great Britain (overall tax burden: 22.7 million marks). In a separate analysis, Germany even shows the lowest tax burden for shareholders of a medium-sized company.

In order to achieve its goals of a corporate taxation model that is irrespective of legal form as well as a continued tax burden relief for business partnerships, the Federal Government will implement an option model. This model allows for the possibility of unincorporated entities to be taxed as a corporation. If the unincorporated entity opts for this alternative, the result is – subject to an expected transformation-induced partial reversion of hidden reserves – a taxation irrespective of legal form. Due to the partial definitive taxation of dividends as part of the half-rate method, this alternative option results in an increased tax burden for small and medium-sized enterprises, and especially for low-profit enterprises, compared to the previous system. For unincorporated entities that do not opt for this alternative the reform proposals of the Federal Government offers the possibility to offset the trade tax against the income tax. However, this solution leads to a taxation respective of legal form. A tax relief for particularly low-profit unincorporated entities resulting from the offset of the trade tax also has its drawbacks as it goes against the tax reform's aim of a taxation irrespective of legal form.

The deduction of the trade tax is limited to the double base rate of the trade tax. As a result of this offset possibility, the tax reform has an impact on municipal finances. Since the trade tax is only taken into account for the fictional assessment rate of 200 percent, especially municipalities with great fiscal capacity are favoured. This is a direct result of the fact that the relief effect is proportional to the trade revenue. Municipalities with low rates of assessment also benefit from the deduction of trade tax from the income tax, even though this benefit is very limited due to the fact that the trade tax itself is deductible when determining the trade revenue, which reduces the relief effect. The higher the rate of assessment, the lower the relief effect. Municipalities with low rates of assessment therefore experience a greater tax relief. Contrary the statements of the Ministry of Finance, the benefit for less favoured locations is questionable. The possible advantage due to lower assessment rates stands opposed to the favouring of the  more productive locations by the profit-related tax relief. At most it can be noted that the trade tax constitutes an improvement on the income tax, which consists in strengthening the location competition and promoting local autonomy. In conclusion it must be noted that the corporate tax reform sends out some very positive signals. However, there are also some objections. The goal of the Federal Government to sustainably reduce the tax burden concerning retained profits is achieved by the proposed measures. This will strengthen the equity base of the company, improve the international competitiveness of German companies and increases the attractiveness of Germany as a location for domestic and foreign investors. Generating a tax relief by significantly reducing the tax rate while at the same time broadening the tax base is to be welcomed from a systematic point of view and with regard to the signal effect of tax rate reductions. Particularly in view of the increasing international competition among tax systems to create attractive location conditions, there is an apparent tendency to reduce tax rates by international standards. Multinational companies base their location and investment decisions primarily on the nominal tax rates, which is easy to determine, and less on the effective tax burden, which by contrast is difficult to measure.  Accordingly, (covert) differences in the assessment base are a far less decisive factor for their decisions. For this reason, in terms of tax conditions the attractiveness of Germany is likely to increase more in an international comparison by lowering the tax rates while at the same time broadening the tax base than would be the case for a reduction in the tax base at constant tax rates.

In the context of cross-border activities, the planned tax reform could even have positive revenue effects despite tax cut. This is true at least if foreign investors are beginning to move from the previously privileged debt financing to equity financing with the result that profits are increasingly taxed in Germany. Furthermore, incentives for large German companies to relocate their production abroad for tax reasons are lowered by the reform. It is unclear, however, whether the proposed tax changes, as intended by the Federal Government, actually increases the willingness to invest in Germany since the tax rate reduction first and foremost has favourable effects on all investments, including insignificant financial assets from a real economy point of view. However, the benefits for capital expenditures are lower, since the advantage of the depreciation accounting is reduced with a decreasing tax rate. In addition, the explicitly deteriorated conditions for depreciation, which are exclusively detrimental to machinery and building investments. The main objection to the proposed implementation of the tax cuts is the dubious distinction of investments carried out within a company, which thus benefit from lower tax rates, as opposed to comparable non-beneficiary investments in the private sector. Favouring "corporate" profits principally promotes the retention or integration of those profits into the company's assets. This is unacceptable from a political and allocational point of view and leads to numerous problems of demarcation.

Additional distortions arise from the abolition of the corporate income tax full imputation system and its replacement by the so-called half-income method. According to the Federal Government, the imputation system is not tenable under European law. Key provisions of the EC Treaty are violated, if German dividends are entitled to offset corporation tax while foreign dividends are not, since in this case foreign investment is discriminated. For the half-income method there are no such concerns on the part of European law, since the planned reduction mechanism applies for domestic and foreign dividends. However, this improvement of international neutrality of the tax system comes with several new distortions in the national area. Since the personal income tax rate of the shareholder determines in the future whether corporations should rather use equity or debt as a financing tool and whether corporation profits should rather be distributed to the shareholder via dividends or shareholder agreements (e.g. salaries), the effects of the proposed tax reform on operational decisions remain completely uncertain. The same applies to unincorporated entities who decide to be taxed as a corporation, as well as in terms of differences in the tax burden between business liable to corporation tax and unincorporated entities that continue to be liable to income tax. As a result of the abolition of the imputation system, whose suitability for Europe can be established in principle by a so-called cross-border imputation, there is even less competitive neutrality of taxation in the future as compared to now.

Contact

Prof. Dr. Thiess Büttner, E-mail: buettner@zew.de

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

Prof.  Dr. Robert Schwager, E-mail: schwager@zew.de

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

Nominal tax rates on company profits:

a European comparison (in per cent)