IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
As we have reported here in last year’s IREF Yearbook on taxation, the German government that has been newly elected in autumn 2009 did have plans for a comprehensive tax reform. These plans included the introduction of an income tax schedule with stepwise increasing marginal tax rates, and possibly only three rates of 10, 25 and 35 percent. There had already been some doubts last year that a majority for such an ambitious reform could be organized. And indeed, the conservative-liberal federal government was characterized by almost complete fiscal policy inertia in its first months.
The plan apparently was to sit out important state elections in Northrhine-Westphalia before introducing potentially controversial legislation on income tax reform. This plan, however, failed miserably when the state elections, and with them also the majority in the Bundesrat, the upper chamber of parliament at the federal level, were lost to the left-leaning opposition parties. Under this new set of political restrictions, a large-scale reform of the German income tax along the lines of the federal government’s initial plans becomes very unlikely. Rather, inertia is likely to persist indefinitely, since a window of opportunity with a centre-right majority in both houses of parliament is very unlikely to open up again within the next years. The second major project announced in 2009 was a reform of municipal taxes, which included plans to abolish the local business tax (the Gewerbesteuer) and to substitute it with other sources of revenue for the local level, such as an increased share in VAT revenue or a local surcharge on the personal income tax. Such plans would have led both to a significant simplification of the tax system (the Gewerbesteuer is quite costly to administer, since its tax base is different from that of the corporate income tax), and to a large reduction of the tax burden on corporate income. The remaining tax burdens on the corporate level would have been only the corporate income tax at a rate of 15%, and the solidarity surcharge of 5.5%. However, this second major reform project is also in danger of failing.
In November 2010, Wolfgang Schäuble, the federal minister of finance, has introduced a novel proposition for the reform of local taxes. The main pillar of the Schäuble Plan is to allow municipalities to levy a surcharge on the personal income tax. However, in contradiction to the coalition accord between the centre-right parties, and contrary to the pundits’ initial understanding, this proposition does not include the abolishing of the local business tax. Instead, Schäuble proposes to lower the federal income tax burden in order to compensate for municipal surcharges. His aim is to adjust the federal income tax schedule such that the overall tax burden remains roughly the same for individuals residing in a typical municipality that levies an average surcharge.
The main thrust of Schäuble’s concept is somewhat surprising, since the abolishment of the local business tax is a major political goal of his liberal coalition partners, and the coalition accord explicitly mentions it. But in the discussions on local tax reform, the aim of granting municipal governments more flexibility to adjust their tax revenues to local financing needs currently overrides the aim of reducing the tax burden on businesses. Quite to the contrary: Plans to even revitalize the Gewerbesteuer by also forcing self-employed freelancers such as attorneys, tax advisers or even doctors to pay the tax are currently gaining some political momentum. From the opposition parties and from some representatives of municipal governments, there are even suggestions to extend the tax base further beyond profits and to include capital employed, or the sum of wages in order to have a tax base that is less volatile over the business cycle.
While there is no acute danger of such more extreme propositions turning into actual policy, one has to bear in mind that any reform of municipal taxes needs a majority in the Bundesrat. Since the centre-right government does not have a majority there, any piece of legislation on comprehensive local tax reform will necessarily have to be a compromise and include some measures favoured by the left-leaning opposition parties. Postponing the reform and remaining in the status quo indefinitely may, on the other hand, not be an option. Local jurisdictions have become increasingly indebted in the recent years, and there is a structural incongruence between their revenue and their financing needs, where the latter follows to large extent from spending decisions made on the central level.
Some changes in detail
There is a long list of small changes to the tax system coming into effect in 2011. The purpose clearly is to facilitate fiscal consolidation, and the method is to increase (or even invent) many small taxes, each of which is not felt to a large extent by the taxpayers. The aggregate revenue from all these small taxes is, however, expected to be significant. From a theoretical perspective, it is rather obvious that the government attempts to exploit the phenomenon known as fiscal illusion. The most important of these small tax increases are the following:
> The option for degressive write-downs will be removed. From 2011 onwards, only linear deductions are possible. The degressive option had been introduced in 2009 in order to provide an investment stimulus during the economic crisis.
> Flying from Germany will become somewhat more expensive in 2011. Short flights up to 2.500 km are charged an air travel tax of € 8 per person, flights up to 6.000 km are taxed at € 25 and longer flights are worth € 45.
> A fee on electric energy intended to finance transfers to suppliers of ecologically sustainable energy rises from 2.04 ct. per kilowatt-hour to 3.53 ct. Given the market situation, it is expected that this will translate into an increase of 10 to 15% in the price of electricity in Germany.
> Smoking will become more expensive. From May 2011, the tax on a standard pack of cigarettes will increase by 8 ct.
> Taxpayers have a right to receive interest payments by the tax administration if refunds take more than 15 months. From 2011 on, these interest payments themselves will count as taxable income.
On the other hand, there are also a few small changes that will benefit taxpayers. The lump-sum tax allowance for employed persons will increase from € 920 to € 1000. If they do not have additional income e.g. from self-employment, then employed taxpayers and retired persons now have an option to file a tax declaration only every two years and not annually, and it is again allowed to deduct costs for a home-office from the taxable income.
By and large, 2010 has however been an extraordinarily calm year in German tax policy. As can be seen above, the legislative and judicial steps taken all are piecemeal changes.
There has been some political and legal controversy recently over the question if illegally obtained data can legally be used in the prosecution of tax evaders. In several cases during the recent months, law enforcement authorities had been offered to buy copies of data CDs containing client data of banks from Switzerland and other countries. With the tax law being enforced by state-level authorities in Germany, some states decided to buy stolen data, while others did not due to legal concerns. Moreover, there have also been several ethical objections against the state paying seven-digit amounts to criminals who trade stolen data. However, in late November 2010 the Constitutional Court has ruled that this process is legal: The fact that data on clients of foreign banks has been collected illegally does not protect tax evaders from prosecution, even if the accusations rely entirely on illegal sources of information.
Tax evasion has therefore become significantly more risky for German citizens in the past years, given these legal clarifications, and given also the inability of many foreign banks to protect their client data. At the same time, and following another high court decision, the government has decided to narrow the conditions that allow tax evaders to avoid prosecution by voluntarily submitting a corrected tax declaration. So far, a taxpayer had the opportunity to salve his conscience without fear of punishment by reporting previously underreported income before the formal process of law enforcement began. This was also the case for partial revelations. Suppose a tax evader has some income underreported from x, and some from y. If he has reason to believe that his secret on x is not safe, then under the old law he had an opportunity to declare x, and even if y were also discovered by the tax authorities later, his evasion of income from x would not be punished. This option for a tactical and partial voluntary correction of tax declarations is now void.
Germany is also currently in negotiations with Switzerland. In October 2010, revisions to the German-Swiss-Double-Taxation-Treaty have been agreed upon. Switzerland now follows the OECD standards on tax-related information exchange with Germany. This agreement, however, only concerns new cases of tax evasion. Further negotiations will have to clarify how old cases of tax evasion are to be treated. The German ministry of finance mentions as goals for these negotiations, among others: to legalize untaxed funds hidden in Switzerland, and to enforce retrospective taxation of these funds.
In Germany itself, every taxpayer is now associated with a unique tax identification number that identifies him vis-à-vis the tax authorities. In the near future, employers will report the identification numbers of their employees to the tax authorities, and in return receive information regarding personal tax allowances of their employees, which in turn allows them to calculate the monthly tax amounts that are to be deducted from gross wages.
Despite 2010 having been a calm year for tax policy, there are significant fiscal issues looming at the horizon. Germany has enacted a constitutional debt brake that will gradually come into effect until 2016 (on the federal level) and 2020 (on the state level). It will require low regular deficits at a maximum of 0.35% of GDP on the federal level, and a strict zero deficit policy on the state level. It remains to be seen whether the debt brake will actually discipline fiscal policy, or whether it will turn out to be hapless cheap talk similar to the European Stability and Growth Pact. It is, however, likely that the German government will attempt to avoid the embarrassment of an immediate failure of the debt brake. Given the high level of current deficits – for 2010, a deficit of 4 percent of GDP is predicted – the necessity for fiscal consolidation is obvious.
Some recent developments will support consolidation. Earlier in 2010, the Constitutional Court has ordered a re-calculation of benefits for long-term unemployed persons. The Court has, however, not enforced an increase in benefits, as has been feared by the government beforehand. The problem identified by the Court was a lack of transparency in the calculation of benefits, not the actual amount. The result of the new, transparent calculation is that appropriate benefits are not higher than the status quo. In terms of the fiscal burden, this was a huge relief relative to alternative scenarios that have been considered prior to the ruling of the Constitutional Court. Similarly, the current, relatively rapid growth of Germany’s GDP and the positive macroeconomic indicators for the near future lead to an expectation of increasing tax revenues and a relatively smooth path of fiscal consolidation.
There are, however, also significant risks. Amidst the turmoil of the European debt crisis, interest rates on newly issued German public debt are increasing, albeit from a very low level. Even if there will indeed be no formal introduction of Eurobonds, as the current political situation suggests, debt service is likely to become gradually more expensive for Germany, with the eventual extent of the effect still being very uncertain.
Summing up, it is not unlikely that current macroeconomic developments, in conjuncture with the newly introduced debt brake, will force Germany to choose between significant spending cuts and tax increases sooner rather than later. * Ruprecht-Karls-Universität Heidelberg, Alfred-Weber-Institut für Wirtschaftswissenschaften