Germany: 070. Status Report - German Tax Reform

Last Updated: 7 July 1997
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The political struggle over the Government's tax reform proposals, reported on at length in articles nos. 59 and 60, is continuing. The Government pushed the major reform bills through Parliament at the end of June 1997, but they cannot become law without the consent of the Federal Council, which rejected them in early July. This is only the end of the round, not the entire fight, however. The tax legislation will go to a conference committee where the real work of seeking a compromise will take place. With the summer break impending, it may be sometime in the autumn before the fate of the Great Tax Reform is known.

1. Summary of developments to date

The following is a summary of the main events through July 1997:

  • In late January 1997, a government commission issued the so-called Petersberg Tax Proposals, which called for cuts in the corporate and individual income tax rates by around 25 % and a package of measures to broaden the tax base. The measures were divided into two phases, one to take effect in 1998 and the other in 1999. The overall decrease in income taxes resulting from these proposals was put at just under DM 44 billion (a figure referring to taxes owed for 1999 without regard to actual cash flow). The Government indicated that increases in unspecified indirect taxes, probably VAT or the tax on petrol, would also occur, leaving a net tax reduction of some DM 30 billion. Concurrent with the release of the Petersberg Proposals, the Government also affirmed its intention to repeal the trade tax on capital and reduce the solidarity surcharge by two percentage points (from 7.5 % of personal or corporate income tax to 5.5 %).
  • The opposition Social Democrats immediately rejected the Government plans and criticised the tax revenue estimates on which they were based, stating that the tax reduction (before increase in indirect taxes) would be at least DM 10 billion higher than the Government's projection.
  • In February and March 1997, the Government introduced three separate pieces of legislation, one each for the 1998 and 1999 phase tax reductions and one for repeal of the trade tax on capital. The increase in indirect taxes remained unspecified as to tax or amount and was not included in any of these measures.
  • All three measures require the consent of the Federal Council (Bundesrat) in addition to that of the German Parliament (Bundstag). The Social Democrats (SPD) are viewed as having a fairly certain majority in the Federal Council, which is an assembly of representatives of the German states in which each state has weighted representation. Of the total of 69 votes, 35 are held by states in which the Social Democrats are currently in office (in some cases in coalition with the Green Party). Only 16 are directly controlled by the Government parties, the remainder being held by states governed by coalitions between the SPD and certain Government parties (CDU or FDP). The coalition agreements would oblige such states to abstain from voting in the Federal Council on issues as to which the coalition members are divided. The Social Democrats have been adamant in opposing the 1998 and 1999 tax reforms as proposed by the Government and have insisted on conditions which the Government has so far not accepted for repeal of the trade tax on capital.
  • The bill repealing the trade tax on capital (with notably a 5 point reduction in the accelerated depreciation rate for movable fixed assets as a revenue-increasing countermeasure) has since been ratified by the German Parliament and, predictably, rejected by the Federal Council. The bill is currently in conference committee. The chances for ultimate passage of this bill appear fairly good (cf. Handelsblatt of 4 June 1997, page 6).
  • On 23 April 1997, a Government delegation headed by Helmut Kohl met briefly with senior representatives of the Social Democrats led by Oscar Lafontaine to explore possibilities for a tax compromise. The talks collapsed within less than an hour after their commencement.
  • New estimates of the revenue to be expected from the taxes currently in effect were released in mid-May 1997. These indicated receipts for federal and local government some DM 18 billion below previous forecasts for 1997 and almost DM 32 billion below forecasts for 1998. At the same time, high unemployment was projected to cause some DM 20 billion in unbudgeted outlays.
  • In late May 1997, the Social Democrats unveiled their long-awaited counterproposals for comprehensive tax reform. These proposals are by and large revenue-neutral (see summary in sec. 2 below).
  • In June 1997, the Government amended its proposed legislation to reduce the net tax relief it would confer (see summary in sec. 3 below).
  • The 1998 and 1999 tax reform acts were ratified by the German Parliament over the votes of the Opposition on 26 June 1997 and sent to the Federal Council. The Federal Council promptly rejected the bills, causing them to be sent to a conference committee which will attempt to arrive at a compromise.

2. The Social Democrat (SPD) tax reform proposals

Like tax proposals announced independently by the Green Party roughly one month earlier, the SPD plan is largely revenue-neutral overall, whereas the Government plan provides for large net tax reductions. The SPD plan would take effect almost immediately, whereas the most important measures in the Government plan are scheduled for 1999.

The SPD plan would first of all benefit all wage earners and employers by reducing social charges by 2 percentage points beginning in October 1997 (- DM 30 billion). This is to be partially counterfinanced by a 1 point increase in VAT (+ DM 16 billion) and moderate increases in the taxes on petrol (+ 6 pfennig) and other fuels (total including tax on petrol: + DM 6.5 billion). The SPD stated that the remaining DM 7.5 billion revenue reduction could either be accepted or, if the Government preferred, counterfinanced by postponement of the reduction in the solidarity surcharge.

The SPD plan also includes changes in direct taxes. These alter neither the top personal tax rate (53 %) nor the level at which it commences (DM 120,000 / DM 240,000 for single and joint filers respectively, unchanged since 1987, incidentally). The lowest graduated tax rate would fall from 25.9 % to 22 % and the zero bracket amount would rise steeply by DM 2,000 / DM 4,000 for single and joint filers respectively. Government child support contributions would rise by DM 30 per month per child for each of the first two children. While the Government plan would drop down the lowest tax bracket even further to 15 %, it also contains a sharp jump in rates at the low end of the earnings scale, whereas the SPD rates climb linearly. The SPD's increase in the zero bracket amount is double what the Government proposes. The Government plans no increase at all in child support contributions.

The SPD also stated that it would consider a reduction in the top personal income tax rate if the resulting decrease in revenue was completely counterbalanced by revenue-generating changes. Restrictions on the netting of passive activity losses (in particular, losses from rental of real estate) against other types of income were mentioned as one possibility.

The SPD plan would leave untouched the current tax exemptions for supplements paid to shift workers. It likewise makes no changes in the deductibility of the costs of commuting to work and would not tax the proceeds of existing life insurance policies. All three aspects of the Government plan are highly unpopular with the persons directly affected.

With regard to the taxation of businesses, the SPD plan would repeal the trade tax on capital and lower the corporation tax rate for retained earnings from currently 45 % to 35 %. Both changes are contained in the Government plan as well. However, the SPD would not reduce the corporation tax rate for distributed earnings, which would thus remain at 30 %. The purpose of this is to encourage the reinvestment of business earnings. The proposal is strongly criticised as inhibiting the flow of capital from a business where it cannot be used to one where it can. Furthermore, an unchanged distribution rate would provide no new incentive for foreign investment in Germany, as the profits from such investment would remain subject to relatively high German taxes.

The most innovative proposal of the SPD is to permit partnerships to chose to be taxed as corporations. By so choosing, a partnership could benefit from the low proposed 35 % tax rate on retained earnings, as opposed to personal tax rates for its partners of up to 53 %. The vast majority of German business entities are partnerships.

Under the SPD plan, all reductions in personal or corporate income taxes (- DM 48 billion) are completely counterfinanced by revenue-increasing measures (+ DM 48 billion). A large part (DM 8 billion) of the revenue needed for the above tax-reduction measures would come from reintroduction of a net worth tax for wealthy individuals.

Otherwise, the SPD plan relies largely on measures affecting the taxation of businesses. There is some similarity between certain of these revenue-increasing measures and those contained in the Government plan. A notable difference is that the SPD would not reduce the current rate for accelerated depreciation of movable fixed assets.

3. Changes in the Government tax legislation

Changes made in the 1998 and 1999 tax bills would lower the tax reduction from these measures. The 1998 phase reforms are now predicted to increase tax revenue owed for the year 1998 by some DM 6.2 billion (compared with a reduction of DM 1.3 billion under the March 1997 version of the bill). The 1999 reforms are now forecast to reduce tax revenue owed for 1999 by roughly DM 39.8 billion (compared with a reduction of DM 44.7 billion under the March 1997 version of the bill). The Government still has not committed itself on the contemplated increase in VAT or the tax on petrol and other fuels.

The primary changes in the 1999 phase affect certain highly unpopular measures in the original draft legislation:

  • Instead of a 10 % tax on the (currently tax-free) interest proceeds of long-term life insurance policies, the premiums paid on such policies are to be subject to the 15 % insurance tax to the extent attributable to the risk and administrative cost portions of the policy (generally 20 % of the premium).
  • The speculation holding period for tax-free sale of real property which is not part of a trade or business is to be increased to only 5 years instead of to 10 years as originally planned (current holding period 2 years).
  • Wage substitute payments (e.g. unemployment compensation) are not to be made taxable after all. They remain subject to a progression clause.
  • Tax exempt wage supplements paid for work at night, on holidays, and on Sundays will be reduced in stages over several years instead of being eliminated outright.
  • Linear depreciation for residential rental property not part of a trade or business will be increased from 2 % to 3 % per year in partial compensation for the elimination of the current accelerated depreciation.

The changes made in the 1998 phase include several measures which significantly increase tax revenue. The most important of these relates to loss carrybacks and carryforwards and would take immediate effect, hence applying to losses incurred in 1997 and possibly to those carried forward to 1997. The following list describes this and other major changes:

  • Effective 1997, losses may be carried back only one year instead of the current two subject to an unchanged maximum amount of DM 10 million. Losses which cannot be carried back may still be carried forward without time limit. There are no restrictions on the use of the first DM 2 million of such loss carryforwards. However, the loss carryforward amount in excess of DM 2 million which may be netted against positive income in any given year is limited to half of the positive income in excess of DM 2 million for such year. It is at present unclear whether the new limit on use of loss carryforwards in a given year would apply only to losses generated from 1997 on or whether losses carried forward from years prior to 1997 would, starting in 1997, also be subject to the limit.
  • Changes in the laws governing accruals permitted for or generally used by nuclear energy producers would increase taxes sharply for such taxpayers.
  • The 1998 drop in the rate of accelerated depreciation for moveable fixed assets has been whittled down to three percentage points instead of five as originally intended. Including the 5 percentage point cut planned in connection with the separate legislation repealing the trade tax on capital, the accelerated depreciation rate would thus fall from currently 30 % to 22 % in 1998.

The Government in addition now wishes to increase its share of VAT revenue by DM 3.5 billion at the expense of state government (instead of the originally planed DM 1.5 billion) and is reported to be considering further amendments to restrict the transfer of corporate losses via merger.

4. Outlook

As stated at the outset, the real work of seeking a compromise will take place, if at all, in a conference committee composed of representatives of the German parliament and the Federal Council. The differences between the Government and the Opposition remain considerable. While the announcement of the SPD position and the changes made by the Government have brought movement into the discussion and revealed a certain amount of common ground, the two sides remain far apart. The downturn in the revenue forecasts may incline the Government to bow to pressure from the States for further reduction in the amount of net tax relief. The political uncertainty as to whom the voters will blame more if there is no tax reform at all may induce both sides to make concessions.

Disclaimer and Copyright
This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany). Distribution to third persons is prohibited without our express written consent in advance.

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