The German tax reform of 2001 was an important step towards improving Germany’s attractiveness as a business location. It will help shift the tax bases of international corporations to Germany, attract direct investment, and reduce those investments that were planned for the sole reason of saving taxes. On the whole, the tax system has become more neutral and has lost some of its steering functions. Investments are again moving to where genuine profits are expected.
In a high-tax country like Germany, called-for tax reforms must necessarily lead to reductions in taxes and hence in tax revenue. Tax revenue must not be wiped out altogether, however, since the state needs some means to carry out its tasks. In terms of this trivial postulate, the German tax reform of 2001 was deficient. It not only reduced the revenue from corporate income taxes but effectively allowed it to become negative. Whereas in 2000 tax revenue of €23.6 billion was collected, in 2001 corporate tax revenue was negative, at minus €426 million. Regarding corporation taxes, the state ended up subsidising corporations in 2001 instead of taxing them.
This is an astonishing outcome that nobody could have wanted. How did it come about?
Of less significance was the announced exemption of capital gains, which induced companies to postpone the sale of equity interests, causing reductions in tax revenue even before the exemption took effect. More important was the fact that many companies were able, in 2001, to write off equity stocks of loss-making subsidiaries. This included spectacular write-offs of foreign equity holdings, implying de facto a continued international loss compensation, although this loss compensation was formally not intended. The weak economy, leading to shrinking actual profits and hence tax obligations, has of course also contributed to falling tax revenues.
The main reason for the reduction in tax revenues is, however, that the distribution fiction inherent in the German tax system, which requires companies to distribute first the most highly taxed stocks of previously retained earnings, led to a tax-reducing replacement of old by new equity stocks. A company, which in 2001 distributed earnings that had been taxed at 45% before 1999, and instead retained new earnings, was rewarded for the mere equity replacement, i.e. without any net retentions, with tax savings of 15% on the replacement volume. The retention of current earnings changed nothing on their taxation at 25%, but the distribution of past, previously retained earnings reduced their tax burden from 45% to 30%. Somewhat lower were the gains on the distribution of retained earnings which had been taxed at 40% in 1999 and 2000. This rule is largely valid until 2016.
Although the tax reduction to 30% in case of distribution was also embedded in the old law, it was the change to the 25% tax rate on retained earnings which caused the tax on distributed earnings to fall de facto to 10% or 15%, respectively, as the result of distributing new earnings via old equity. By permitting, despite the tax reduction, a replacement of old by new equity, the tax reform – which, if one believes the policy statements, was intended to apply to newly retained earnings – was extended to earnings retained in past years. In practice, taxes were reduced on the entire stock of equity capital that German corporations had retained since the tax reform of 1977. German shareholders were handed genuine gifts.
The gifts to shareholders were unnecessary. If you want to promote growth it is irrational to reward the replacement of old retained earnings with new earnings by lowering taxes. Tax reductions on the exchange of equity will not have positive effects on growth. New, growth creating investments can only be induced by reducing taxes on the profits used for them or earned by the investments themselves.
The objective of the tax reform was to encourage the retention of profits. Promoting the enterprises, not the entrepreneurs was the slogan. But various aspects of the transition rules had the very opposite effect, i.e. a greater distribution of profits following the reform. This weakened rather than strengthened the equity base of the companies, and weakened the firms' resistance to crisis.
In technical terms it would have been easy to design the tax reform differently with regard to the treatment of retained profits. Lawmakers could have declared taxes previously paid as definitive, similar to what happened in 1977 when the full tax imputation system was introduced. That would have raised legal questions, however. As an alternative one could have made the rule that retained profits which replace old equity are taxed at the same rate as these, and that only additionally retained earnings will enjoy the tax reduction to 25%. Easiest would have been a change in the order of distribution of the retained earnings. Instead of the distribution method according to the most highly taxed equity, one could have applied the LIFO method – last in first out. In that case the firms would not have been able to reduce their tax obligation by simply switching equity stocks. In a normally growing economy with rising stocks of equity, the tax gifts would have largely been avoided.
We will have to see how the corporation income tax revenue will develop despite the design flaws. Expectations for 2002 are poor. In Bavaria the alarm bells went off early, but North Rhine- Westphalia and Hesse were hit especially hard. Together they had to reimburse over €1 billion more in corporation taxes than they received in the first half of the year. The effects are not at all uniform in the various Laender. For the Federal Republic as a whole, the corporation income tax "yielded" minus €1.3 billion in the first half of 2002. During the same period of 2001, genuine revenue had amounted to more than €2 billion, despite the negative overall revenue in 2001 already mentioned. Many corporations seem only just now to be realising the new opportunities for exploiting the law and have until 2016 to use the tax-reducing equity switch. To be sure, from 2002 or in some cases 2003, it is no longer possible to use tax-effective write-offs on share holdings so that the tax shortfalls of 2001 may not be permanent. However, substantial losses may be repeated due to tax savings resulting from the distribution of old equity stocks.
The tax reform was good, but it was too much of a good thing. Instead of reimbursing taxes on replaced equity, one could have reduced the extreme disincentive to work caused by the personal income tax. And one could have extended better treatment to the unincorporated firms, especially small and medium-size firms. This would have been better for economic growth and overall efficiency.
Professor of Economics and Public Finance
President of the Ifo Institute