Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
and economic freedom

Taxation in Germany compared to other European tax systems

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Taxation in Europe - Yearbook 2013


The big picture

German fiscal policy is at present conducted under very favorable conditions. Capital flight into Germany during the Euro crisis has led to historically low interest rates on newly issued German public debt. Despite a not very low debt-to- GDP ratio of more than 80%, the absolute level of interest payments remains very low, and the share of interest payments in total public spending is not triggering any worries in the short or medium term. There are, however, also some risks in the seemingly very robust German fiscal situation. First and foremost, it is far from certain that low interest rates will remain on their historically low levels in the longer run. The emerging risk-sharing mechanisms within the Eurozone imply that fiscal problems of periphery countries could quickly translate into higher debt burdens for Germany itself. If on the other hand the troubles in the Eurozone are finally resolved, then the role of Germany as a safe haven for bondholders will also decline, and interest rates will rise to more conventional levels again. One way or the other, the country needs to prepare itself for the future by reducing public debt.

Germany’s fiscal policymakers are already preparing for the constitutional debt brake, which will come into full effect from 2016, and aims at reducing the scope for public deficits on the federal level to 0.35% p.a. (structural deficit), and at completely eliminating structural budget deficits on the sub-central level. While preparations for the debt brake are slow and behind schedule in some sub-central states, like the largest state Northrhine-Westphalia, the federal government is expecting budget surpluses in the near future. This is both due to a strong increase in tax revenue, as Germany is one of the few Eurozone economies not hit by a recession recently, but also due to a decline of public spending relative to GDP. This share, which had reached levels below 44% before the financial crisis and increased to more than 48% in 2009, is expected to return to 44% by 2016.

Meanwhile, the German tax system still suffers from a number of serious problems. The income tax schedule is generally considered to be too progressive for middle-income earners, and therefore associated with adverse incentive effects on labor supply. The problem of cold progression (see previous issue of the Yearbook), which could technically be solved by simple inflation-indexing of the income tax schedule, is still unresolved. Sub-central jurisdictions, both states and municipalities, suffer from structural underfinancing that could be resolved with an increase in sub-central fiscal autonomy. These are only some representative issues that wait to be tackled; more will be discussed in the following paragraphs.

Recent changes in tax policy in Germany

There are two obstacles to tax reform in Germany at present: One is the abovementioned priority of budget consolidation and debt reduction. The German government is at this time not interested in large-scale tax reforms with uncertain revenue effects, but prefers a reliable stream of tax revenue that allows fiscal consolidation to be engineered with as few surprises as possible. The other obstacle is of a political kind. The centre-right federal government currently faces a left-wing majority in the upper chamber of parliament, the Bundesrat, which does not show any enthusiasm for tax cuts or efficiency-oriented reforms, even if they could be expected to be revenue-neutral. On the contrary, the strategy of the Social Democrats and the Greens appears to be the stalling of any important legislative initiatives by the government until the federal elections, which will take place in autumn this year. The opposition thereby revives a strategy that had already been successful for them prior to the 1998 federal election, which ended the Kohl government.

The policy preferences of both political camps on tax policy and fiscal policy in general are indeed in strong contradiction. For example, the federal government has in 2011 started a legislative initiative to reduce cold progression in the income tax, which has subsequently been vetoed by the Bundesrat in May 2012. The Social Democrat party runs its federal election campaign with the promise to increase top income tax rates from 45% to 49%, which is opposed by the current centre-right government. The government also opposes proposals by the Green party to re-introduce a reformed net wealth tax, which had been abolished in its old form in 1997, after having been ruled unconstitutional by the constitutional court. A majority in the Bundesrat is strongly in favor of extending income tax privileges intended for married couples to homosexual relationships, which is – so far – opposed by the Christian Democrats and therefore by the government. These are examples for strong ideological divisions on tax policy, and only the autumn federal election will reveal which fiscal policy program will eventually prevail.

Only few actual changes to the fiscal burden of taxpayers can be reported. The contribution rate to the mandatory public pension system has been cut from 19.9% in 2011 to 18.9% in 2013, which was possible due to the very positive development on the labor market. Deductibility of child-care expenses for working parents has become more generous in 2012, in another attempt to influence demographics through tax incentives. Cold progression still works very much in favor of the government and against the taxpayer; it is estimated that about € 3 bn in extra revenue in 2012 was due to higher nominal wages being taxed at higher marginal tax rates in the progressive income tax system.

The tax on nuclear fuels used in nuclear power plants, which was invented in 2011, is currently the subject of a legal controversy and is deemed unconstitutional by several courts. The issue has now been deferred to the constitutional court. While the tax itself – with a tax burden of € 145 per gramme of nuclear fuel – may seem a bit odd and irrelevant on first sight, it has yielded € 1,6 bn in 2011 and was initially expected to generate up to € 2,3 bn in annual revenues. Thus, there is a substantial amount at stake for the federal government, and also for the private energy producers who are liable to pay the tax, and also for the demand side of energy market, which eventually carries some of the tax burden through higher energy prices.

The federal government is still actively supporting the introduction of a financial transaction tax on the European level. If British legal action against the introduction of the tax is not successful and everything goes as planned, then 11 European countries including Germany and France will introduce such a tax starting January 2014. While such a tax is immensely popular among voters in Germany, the financial sector is still campaigning against it. Even the stateowned LBBW bank is part of this campaign; it’s CEO has recently argued that the bank may even be forced to go out of business if the burden of the financial transaction tax comes as planned. It remains to be seen if the campaign of the opponents of a financial transaction tax in Germany gains some traction in time before the legislative process is completed. Considering the so far broad political support, it is however highly unlikely that plans to introduce the tax will be stopped.

A spectacular event of German tax policy was the demise of the newly negotiated tax treaty between Germany and Switzerland. The treaty would have included a de facto amnesty for German tax evaders with hidden assets in Switzerland, albeit at a high price: Up to 41% of undeclared assets would have been automatically withheld in Switzerland and transferred to the German tax administration. A windfall of up to € 10 bn in revenues was expected by the German government. The left-wing majority in the Bundesrat was, however, strongly opposed to the tax treaty due to a perception of injustice with regard to the tax amnesty. Social Democrats and Greens prefer an, albeit costly, legal prosecution of tax evaders to the automatic taxation at the source and subsequent legalization of undeclared assets. With stolen data on German accounts in Switzerland now being sold often and almost routinely to German tax authorities, any plan for an amnesty for tax evaders has also become very unpopular among voters in Germany.

Further developments and discussions on German tax policy

It is one of the prime objectives of the current German government (and also of any reasonably likely successor) to fight tax evasion. Germany is very active in organizing political pressure on so-called tax havens to become more transparent. The already mentioned tax treaty with Switzerland, which contained very favorable provisions for Germany, is an example showing that this strategy can be very successful. The eventual demise of the treaty is to be explained with partisan politics in Germany, and should not be interpreted as a failure to come to reasonable terms with a country that is perceived as a tax haven. The next countries that are likely to be the target of similar political pressure are Luxembourg and Austria.

Ireland and the Netherlands, as two countries that facilitate legal tax avoidance for businesses, will also be exposed to more intense political bullying soon. In particular, the German finance ministry is an avid supporter of an OECD project against the erosion of tax bases in international corporate taxation. It is useful to remember that the campaign against income tax havens at its early stages also featured prominently a naming and shaming of the chief culprits by the OECD. The first OECD report on Addressing Base Erosion and Profit Shifting has been produced in early 2013, and it promises the development of a "global and comprehensive action plan" in the foreseeable future. In a similar direction, the German government also supports an initiative of the European Commission to reduce the scope for legal business tax avoidance, and the implementation of a so-called common consolidated corporate tax base in the EU that would put severe restrictions on international profit shifting within the EU.

Domestically, the necessity to reform the property tax (Grundsteuer) becomes more acute with time. The tax rests on a federal law, but gives local municipalities the autonomy to set tax rates and to collect and keep the revenue. There is a high likelihood that the property tax will be ruled unconstitutional in its current form by the constitutional court. The reason is that the values of property that enter the tax base are in general not current market values, but are based on estimates which are, in West Germany, almost five decades old. This is especially problematic for property with buildings, or even new buildings, whose market value may far exceed the old approximated values. Different reform options for the tax base are currently discussed: i) only the physical space of property, but not the value could serve as a tax base; ii) the use of current market values; iii) the use of the market value of the land, and the physical space of buildings as a tax base.

The first and third options attempt to circumvent the tedious task of keeping records of current building values. The first reform option is associated with very low administrative costs, but may be perceived as unjust in a world with large local variations in property values. The third option is a compromise in this respect, with land values often being easier to approximate than values of buildings. The second option can probably be considered the most equitable if ability to pay is the relevant criterion, but it is also associated with particularly high costs of tax administration. So far, it is uncertain which reform approach will receive the largest political support. A large coalition of local politicians is however in favor of simplifying the tax and keeping the costs of tax administration as low as possible, which clearly speaks against the second reform option.

Finally, the inheritance tax is also a candidate for reform again, after the last broad overhaul took place as recently as January 2008. The main problem here is the existence of generous tax exemptions for inherited businesses. The purpose of these exemptions is not to burden ongoing businesses with inheritance taxes, in order to avoid liquidity problems in case of a transfer of ownership from one generation to the next. The problem is now that these exemptions can also be used as a vehicle to avoid inheritance tax on non-business wealth transfers, through the shift of private assets into a business, which even may only be founded for the sole purpose of inheritance tax avoidance (the so-called "Cash GmbH"). There is a widespread consensus across the political spectrum that this type of abuse of the original tax exemption should be made more difficult, and legislation is likely to pass before the autumn elections.

In addition to this, there is also the possibility that tax exemptions for businesses in the inheritance tax will be outlawed completely by the constitutional court. Positive discrimination that favors specific types of transferred wealth relative to others may be unconstitutional: A certain interpretation of the German constitution demands that all types of wealth are treated equally in case of an inheritance. If the court will indeed rule along these lines, and the tax exemptions for businesses will have to be abolished completely, then the problem arises again that the inheritance tax may be associated with highly negative effects on the liquidity of ongoing businesses. Another larger-scale reform of the inheritance tax would be a probable outcome.

Summary and discussion

Institutional, macroeconomic and political restrictions presently pose as obstacles against large-scale tax reforms in Germany. There would be plenty of tasks for policymakers, in particular with regard to simplifying the income tax and making it more efficient, but it is highly unlikely that the necessary majority in both houses of parliament could be secured at any time soon. In general, politics is currently often pushed into action by the constitutional court, instead of becoming active by itself. The frequency with which constitutional doubts with regard to the legality of tax laws occur, and also prove to be correct, is disappointing. The legal quality of the tax laws coming out of the legislative process appears to be deteriorating more and more.

The upcoming autumn elections are very important for the further development of tax policy. If the current opposition wins the election, it will have a majority in both houses of parliament and is likely to use it to increase the top rate of the income tax to 49%. It is also likely that other taxes and public spending would increase. If on the other hand the current government is re-elected, the current political situation will be prolonged, and the scope for decisive action in fiscal policy would remain small for the foreseeable future.

Jan Schnellenbarch, PD Dr.
Ruprecht-Karls-Universität Heidelberg
Alfred-Weber-Institut für Wirtschaftwissenschaften
and Walter-Eucken-Institut, Freiburg im Breisgau

This is part of :

Taxation in Europe - Yearbook 2013
The yearly report on the evolution of European tax systems

A short presentation of IREF ’Yearbook on Taxation in Europe’ Series
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