2008 Corporate Tax Reform – Federal Government's Plans on the Brink of Failure

The federal government's plans for the 2008 corporate tax reform cannot meet their own requirements. The tax reform is neither expected to significantly improve the fiscal attractiveness of German locations nor the conditions for investment and growth.

High profit companies will benefit the most from this reform whereas indebted and innovative enterprises with start-up losses as well as middle class will have to face the highest losses. Furthermore, basic principles of income taxation may be violated and there is finally the risk of fading trust in the reliability of German fiscal policy. These are the findings of a study on the impact of the planned corporate tax reform conducted by the Centre for European Economic Research (ZEW), Mannheim, and the University of Mannheim.

On 12 July 2006, the cabinet agreed upon the cornerstones of the corporate tax reform planned for 2008. Income tax rates on corporation profits are to decrease to less than 30 per cent. In addition, the rate of corporation tax will be halved from 25 to 12.5 per cent and the tax assessment rate for trade tax is supposed to be reduced from 5 to 4 per cent. At the same time, the deductibility of trade tax as operating expenditure will be abolished.

The federal government is currently examining three options of financing tax losses from tariff reductions:

(1) adding on 50 per cent of short and long-term interest on borrowing capital plus an interest portion of rents, leases and leasing rates;

(2) fully including short and long-term interest on borrowing capital;

(3) limiting the annual reduction of interest on borrowing capital to 60 per cent of the profit before the inclusion of interest on borrowing capital if a basic amount of 1 million euros is exceeded; the non-deductible portion can be carried forward for an indefinite period.

The "European Tax Analyzer" developed by ZEW in collaboration with the University of Mannheim, made it possible to assess the impact of the planned measures on the effective tax burden on German corporations. The researchers assumed a reduction of corporation tax rates including solidarity surcharge and trade tax at company level from currently 39 per cent to 30 per cent. The three options under discussion were examined separately as to their counter-financing potential.

Over a ten-period horizon, a typical medium-sized company in the manufacturing industry benefits from cost reductions. However, they vary depending on the counter financing measure. If half of the interest is added (option 1), the average reduction will range at 17 per cent whereas an absolute prohibition of interest deductions (option 2) would lead to reductions of only 12 per cent. If the deduction is limited to 60 per cent of the profit (option 3), reductions will amount to approximately 25 per cent.

The measures planned particularly relieve high profit companies and those that are financed with equity capital. With growing debts and deteriorating results of operations, companies benefit significantly less. The result may be additional burdens at branch level, for example in the transport sector (almost 20 per cent). Highly innovative and thus more risk-averse companies, which usually face start-up losses, benefit least from the reform.

On an international level, Germany would improve just marginally. It currently ranks second last among 12 countries. If the deduction restrictions for interest on borrowing capital apply, German corporations will climb only two ranks taking the ninth position. Thus, the reform does not entail a considerable improvement of Germany’s fiscal attractiveness or the conditions for investment and growth whatsoever. Such improvements require deduction restrictions that are less drastic.

The federal government’s plans for the 2008 corporate tax reform also include the introduction of a withholding tax of 30 per cent to simplify taxation and improve the financial neutrality of the taxation of private investment income. Due to dividends and realised capital gains the existing half-income system ceases to apply.

Combined with the scheduled restrictions on interest deductions at company level, the planned withholding tax leads to double taxation of generated company earnings. This usually involves an increased tax burden for medium-sized enterprises for which the total tax burden at company and shareholder level is important. Depending on the extent of deduction restrictions, the additional burden ranges from 1.7 to 4.15 per cent. Hence, the fiscal competitiveness of medium-sized enterprises deteriorates leaving them less competitive than firms based abroad.

The study has been published in the renowned periodical "Der Betrieb" in German language

Christoph Spengel and Timo Reister (2006), Die Pläne zur Unternehmenssteuerreform 2008 drohen ihre Ziele zu verfehlen (2008 Corporate Tax Reform – Federal Government’s Plans on the Brink of Failure), Der Betrieb 59, 1741-1747.

Contact

PD Dr. Friedrich Heinemann, Phone +49(0)621/1235-149, E-mail heinemann@zew.de  

Dr. Christina Elschner, Phone +49(0)621/1235-142, E-mail elschner@zew.de