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1. THE PETERSBERG TAX PROPOSALS
Announced on January 23rd of this year, the "Petersberg Tax Proposals" outline a plan of fundamental income tax reform authored by an expert commission headed by the Minister of Finance and endorsed by the three parties comprising the coalition which has been governing Germany for the past 15 years. Daring not just by comparison with the recently legislated 1997 Annual Tax Act, the recommendations would cut tax rates by around 25 % and greatly broaden the tax base.
While numerous aspects of the proposals are still controversial, their overall magnitude is impressive:
DM billions Lower tax rates (wo. solidarity surcharge) - 81.95 Tax increases (broader tax base) + 38.12 --------------- Decrease in tax revenue - 43.83 Lower tax rates (solidarity surcharge) - 7.50 Increases in indirect taxes (e.g. VAT + 1 %) + 15.00 --------------- - 36.33
Strictly speaking, the Petersberg Proposals assume, but do not formally "recommend" a two percentage point reduction in the solidarity surcharge. More importantly, they make no recommendation on increasing indirect taxes, such as VAT or the tax on petrol. Political resistance is strong to even a 1 point increase, as VAT is regarded as a regressive tax by the opposition Social Democrats. Their consent, and to some extent that of the Greens, is necessary to enact the proposed legislation because the Government commands no majority in the Federal Council (Bundesrat).
The Petersberg Proposals have been controversially discussed in Germany in the two months since their release. This article focuses on the Proposals as originally released and mentions only what seems to be the most important subsequent developments. The article does not present the political debate regarding the Proposals. Nor does it attempt to detail all corrections and refinements since made in the figures initially released with the Proposals.
On 14 March 1997, the Government presented a mammoth 400 page draft of the proposed legislation based on the Petersberg Proposals. The length of the draft is largely a result of the Government's decision to completely renumber and reorganise the German income tax law for the first time since 1934. The March 14th draft legislation and the revised estimates it contains regarding the effects of the proposed changes on tax revenue have not been analysed for the purposes of this article.
2. TRADE TAX ON CAPITAL
The Petersberg Proposals are silent on the issue of repeal of the trade tax on capital. A measure passed by Parliament on 28 February 1997 would abolish the trade tax on capital from 1998 on and make changes reducing the impact of the trade tax on earnings on individuals. The measures are financed by a decrease in the rate for accelerated depreciation of movable fixed assets from 30 % to 25 %. Since the revenue from the trade tax largely goes to local government, the Government bill contains provisions granting local government a larger share of value added tax revenue. Overall, the packet of measures requires the approval of the Bundesrat and a constitutional amendment (two-thirds majority in both Parliament and the Bundesrat) to take effect. Since the bill was enacted against the votes of the Social Democrats, it may be presumed that the last word has not yet been spoken on this subject. The Social Democrats are not opposed to repealing the trade tax on capital as such, but their conditions have not yet been met by the Government.
3. THE GOVERNMENT'S CASE FOR TAX REFORM
The reasons advanced in support of the reform proposals are as follows:
1. From a tax perspective, Germany is presently considered unattractive as a business location compared with other countries. The danger is perceived that foreign businesses will pass Germany over when selecting the site for future expansion and above all that German businesses will invest abroad rather than at home. Consequently, measures are necessary to improve the conditions of production, investment, and employment in Germany in order to secure Germany's future as a business location.
2. High income tax rates are identified as a major cause of the competitive disadvantage at which Germany finds itself. Other negative factors are the complexity of the German tax system and the high share of gross national product claimed by direct taxation.
3. The present tax system should also be made more equitable (and at the same time simplified) by eliminating or curtailing special benefits of numerous sorts.
4. Lowering the tax rates while eliminating or attenuating various tax breaks will reward and stimulate economic activity by reducing both the availability of and the incentive for tax-driven investments. Presently, personal taxable income of DM 120,000 (DM 240,000 for joint returns) is subject to a marginal tax rate of 53 % + solidarity surcharge 7.5 % on 53 % = 56.5 %.
5. In conjunction with reform of the social security system, tax reform will stimulate German economic growth and create high-quality and long-lasting jobs. This latter objective appears particularly urgent in light of the new postwar unemployment record set in Germany in January of this year.
4. PHASED INTRODUCTION OF THE REFORMS
The proposed changes are to take effect in two phases. The Ministry of Finance presented in mid-February a draft of the proposed Phase I changes (Draft Tax Reform Act of 1998). This was originally to include a sharp increase, to take effect from 1 January 1997, in the reduced capital gains tax rate applying to individuals selling a business, a material ownership interest in a corporation, or an interest in a commercial partnership. In the meantime, however, the Government has decided to postpone the increase in the capital gains tax rate until 1999 (Phase II). Instead, the rate for accelerated depreciation of movable fixed assets is to be reduced by 3 percentage points in 1998. This is in addition to the 5 percentage point reduction planned to finance the repeal of the trade tax on capital (see section 2 above), bringing the rate for accelerated depreciation of movable fixed assets down from 30% to 22% in 1998. In 1999 (Phase II), a further cut of 2 percentage points to 20% is planned.
The Phase I changes apply from 1998. The principal 1998 changes broadening the tax base are as follows:
As mentioned at the end of section 1 above, a draft of the proposed Phase II reforms was released by the Government on 14 March 1997. This draft follows the Petersberg Proposals by and large, but has not been examined for the purposes of this article.
- Mandatory reversal of write-downs taken by reason of declines in value of fixed or current assets when the asset recovers in value.
- Prohibition on accruals by reason of losses anticipated on contracts of continuing obligation (Dauerschuldverhaeltnisse - e.g. loan and rental agreements, long-term delivery contracts).
- Limitation of accrual for losses anticipated from other contracts (e.g. sales and purchases) to the excess of anticipated unrealised losses over unrealised gains.
- Valuation of accrual for contingent liabilities with respect to anticipated actual net liability in light of past experience with comparable liabilities (as opposed to the nominal amount of claims raised - expected to affect insurance companies above all).
The contemplated tax rate changes for Phase I and Phase II are shown in the table which follows.
5. REDUCTIONS IN TAX RATES
The proposed tax rate changes are as follows:
Presently In 1998 In 1999 PERSONAL INCOME TAX Zero bracket amount DM 12,095 DM 12,365 DM 13,014 Lowest marginal tax rate 25.9 % unchanged 15 % Highest marginal tax rate DM 120,000 + unchanged DM 90,000 + Highest tax rate Normal income 53 % unchanged 39 % Commercial business 47 % 40 % 35 % income CORPORATION TAX Rate for retained earnings 45 % 40 % 35 % Rate for distributed earnings 30 % 28 % 25 % Rate for PE of foreign 42 % 37 % 32 % corporations SOLIDARITY SURCHARGE 7.5 % 5.5 % 5.5 % INTERNATIONAL TAXATION ACT Min. rate for corporations to avoid tax haven treatment 30 % unchanged 25 % WITHHOLDING TAX RATES Dividend withholding 25 % unchanged 15 % With. on other income from 25 % - 35 % unchanged 25 % capital
6. BROADENING OF THE TAX BASE
The principal revenue-generating measures in the Petersberg Proposals may be broken down into four categories depending on the class of taxpayers affected. The estimates as to gross revenue impact of the various individual measures are those contained in the Proposals. "Gross revenue impact" is calculated with respect to the existing tax rates. The Proposals put net revenue impact, considering the new reduced rates, at 75 % of the overall gross figure, but provide no figures for the specific measures. The tables which follow list the measures accounting for more than 98 % of the forecast revenue increases. Three quarters of the measures not covered relate to the taxation of farmers and foresters.
The draft legislation released on 14 March 1997 revises the following figures and may make changes in certain measures as well.
PROPOSED MEASURES GROSS REVENUE IMPACT (DM MILLIONS) I. PROPOSALS AFFECTING COMMERCIAL BUSINESSES 1. Repeal of tax exemption for gains, e.g. cancelled debt,realised to rehabilitate insolvent businesses 50 2. Mandatory reversal of write-down of fixed or current assets when asset recovers in value 5,000 3. Elimination of accruals for unrealised losses from contracts of continuing obligation; accrual for unrealised losses on other contracts reduced by amount of unrealised gain 5,000 4. Lower valuation of accruals for contingent liabilities (especially those based on insurance claims) 1,300 5.Limits on roll-over of gain realised on sale of capital assets 200 6. Reduction in accelerated depreciation for movable fixed assets from 30 % to 25 % p.a. 4,300 7. Reduction in straight-line depreciation for buildings held as fixed assets from 4 % p.a. to 3 % p.a.(2 % for residential buildings) 1,800 8. Elimination of special and anticipated depreciation for small and medium sized businesses 1,000 9. Elimination of the valuation discount for certain imported goods purchased 250 10. Elimination of tax free reserve for Bausparkassen of 3 % of deposits in home ownership savings plans 450 ----------- 19,350 =========== II. PROPOSED MEASURES AFFECTING EMPLOYEES 1. Taxation of 50 % of unemployment compensation and other wage substitute payments -300 2. Elimination of exemption for severance payments up to DM 36,000 900 3. Elimination of exemption for employer contributions to cost of commuting using public transport 100 4. Elimination of exemption for certain bonuses (e.g. after 10, 25 or more years of service) 100 5. Elimination of exemption for supplements paid to civil servants working abroad 100 6. Elimination of exemptions for supplements paid for work at night and on Sundays/holidays 2,200 7. Higher taxation of employee rebates 70 8. Reduction in the deduction allowed for cost of commuting between home and work 4,200 9. Reduction of standard deduction for job- related expenses 3,900 10. Elimination of exemption for employee stock issues 180 ----------- 11,450 =========== III. PROPOSED MEASURES AFFECTING SENIOR CITIZENS 1. Reduction in exemption for private pension income 1,100 2. Increased taxation of public pensions and annuities 1,500 3. Reduction in old age deduction amount 400 ----------- 3,000 =========== IV. OTHER PROPOSED MEASURES AFFECTING INDIVIDUALS 1. Taxation of private capital gain on sale of shares in a corporation if interest exceeds 10 % instead of 25 % 500 2. Elimination of exemption for first DM 20,000 of gain on sales of above sort 50 3. Increase in the holding period for tax-free sale of real property from 2 years to 10 years 1,200 4. Increase of holding period for tax-free capital gains on sales of shares and securities from 6 months to 1 year 30 5. 10 % flat rate taxation of interest earned by long-term whole life insurance policies (previously tax free) 3,400 6. Reduction in personal interest income exemption 2,100 7. Termination of accelerated depreciation for rented residential housing (unless held as business property) 2,400 8. Elimination of deduction for interest on overdue, deferred, and suspended taxes 200 9. Elimination of exemption of DM 60,000 for gain on sale of professional service businesses 150 10. Elimination of exemption of DM 60,000 of gain on sale of commercial businesses 300 11. Elimination of deduction for pre-occupancy costs under the German home-ownership subsidy system 700 12. Elimination of taxation at half of normal rate for gains on sale of businesses and other payments; instead, spreading of gain over a 5 year period 5,000 ----------- 16,030 =========== V. SUMMARY GROSS NET 1. Commercial businesses 19,350 2. Employees 11,450 3. Senior citizens 3,000 4. Other measures affecting individuals 16,030 Subtotal 49,830 Total revenue-increasing measures under the Petersberg Proposals 50,830 38,120 Difference 1,000 Percentage of measures covered 98.03% SUMMARY AS A PERCENTAGE OF TOTAL REVENUE- INCREASING MEASURES 1. Commercial businesses 38.07% 2. Employees 22.53% 3. Senior citizens 5.90% 4.Other measures affecting individuals 31.54%
By and large, the items contained in the category "other measures affecting individuals" fall on persons with some degree of wealth. Bearing this in mind, and speaking in very broad terms, it would appear that not quite 70 % of the revenue-generating measures in the Petersberg Proposals (categories 1 and 4 above) will affect persons in the upper income categories.
7. ANALYSIS OF THE PETERSBERG PROPOSALS
An analysis of the Petersberg Proposals must begin with the new personal income tax rate structure. The following tables compare marginal and average income tax rates for single and joint filers under present law and under the Petersberg Proposals:
SINGLE FILERS MARGINAL RATE AVERAGE RATE Taxable Old (%) New (%) Change Old (%) New (%) Change income 20,000 27.3 22.9 -4.4 10.2 6.0 -4.2 40,000 30.9 27.5 -3.4 19.6 15.6 -4.0 60.000 34.8 32.1 -2.6 24.0 20.4 -3.7 80,000 40.8 36.7 -4.1 27.5 23.9 -3.6 100,000 46.9 39.0 -7.9 30.7 26.8 -4.0 120,000 53.0 39.0 -14.0 34.0 28.8 -5.1 200,000 53.0 39.0 -14.0 41.6 32.9 -8.7 300,000 53.0 39.0 -14.0 45.4 34.9 -10.5 JOINT FILERS MARGINAL RATE AVERAGE RATE Taxable Old (%) New (%) Change Old (%) New (%) Change income 40,000 27.3 22.9 -4.4 10.2 6.0 -4.2 60,000 29.1 25.2 -3.9 16.2 12.0 -4.2 100,000 32.8 29.8 -2.9 22.1 18.2 -3.9 200,000 46.9 39.0 -7.9 30.7 26.8 -4.0 300,000 53.0 39.0 -14.0 37.8 30.8 -6.9
One immediately notes that, while the proposed rates bring relief to taxpayers at all income levels, the differences are largest at the lower and above all upper ends. The authors of the Proposals explain the relief for modest incomes in terms of the need to distinguish more clearly the standard of living one can earn at a low-paying job from that to be had without effort by staying on welfare. But they do not say why the marginal rates of persons with incomes above DM 120,000 per year should be reduced by up to 14 percentage points, while those of persons inside the progression range drop by only 3 to 4 percentage points.
Average As Opposed To Marginal Tax Rates
The data on average tax rates contains part of the possible answer. The average tax rate is reduced uniformly (4 to 5 percentage points) up to DM 120,000 for single filers and double this amount for joint filers. An advantage for higher incomes does not emerge until significantly above these figures. Furthermore, Germany's average income tax rates within this range are not excessive by international comparison, especially when one recalls that married couples filing jointly pay tax calculated at double that owing on half their joint income (full splitting). The conclusion drawn by the authors of the Petersberg Proposals would appear to be that drastic tax relief is not needed within this range.
Withdrawal Of Tax Benefits To High-End Taxpayers
Average tax rate reductions do diverge significantly at higher amounts. Since this can hardly be unintentional, one must assume that the new tax rate structure is intended to provide significant relief to persons with incomes well above DM 90,000, at which the new structure reaches its peak rate. The average tax burden on a taxable income of DM 300,000 declines by DM 31,369 (- 23%) from DM 136,141 (45.5 %) to DM 104,772 (34.9 %) under the new tax rate structure. The tax saving for someone with taxable income of DM 100,000 is DM 3,976 (-12.9 %); that for a taxpayer with income of DM 50,000 is DM 1,936 (-17.5 %).
A simple comparison of taxes owing on income is misleading, however, because it ignores the fact that, with rising income, taxpayers become better able to afford and to profit from tax advice so as to reduce their taxable incomes. We have noted above that roughly two thirds of the revenue-generating measures in the Petersberg Proposals would appear to fall on relatively high-income level taxpayers, either directly or as the owners of businesses. It would be jumping to conclusions to assume that all or most of the significant reduction in tax rates accorded to higher-level taxpayers would be neutralised by revenue generating measures, the impact of which is likewise limited to this taxpayer group. Nevertheless, there are indications that at least one objective of the Proposals is to tax wealthy individuals at lower rates, but on a greater percentage of their gross income, in other words, to narrow the difference between gross income and taxable income for such individuals. To this extent, the reduction in tax rates for higher income individuals would not represent a reduction in net income taxes.
Inducement With Respect To Economic Decisions
However, even this is probably only a partial aspect. By reducing tax rates and withdrawing tax concessions for high-level taxpayers, the authors of the Petersberg Proposals are possibly seeking to permit persons of some means to retain roughly the same percentage of income without using of tax shelters as they were before able to secure with the benefit of tax planning, including in some cases semi-legal or downright illegal tax evasion strategies. By relieving the tax pressure on persons with large disposable incomes, the authors of the Proposals may be speculating that such persons will be induced to commit the funds at their command to the domestic economic process, thus creating economic growth and more jobs, instead of channelling them into tax-driven schemes the economic viability of which depends on high marginal tax rates (distortion of economic choices by tax considerations) and/or depositing them in foreign banks or foreign mutual funds paying rates of return which are only attractive if the revenue goes undeclared and so untaxed.
One thing is certain: Lower tax rates mean that the after tax return on straightforward economic activity inside Germany which does not depend on any of the special tax provisions being eliminated or curtailed under the Petersberg Proposals will be significantly greater if the Proposals are enacted into law than if the present structure is retained. And this at least means that a foreign passive investment opportunity would have to pay a higher return in the future to outperform a domestic economic venture on an after-tax basis.
Effect On Business
Turning to the effect of the Petersberg Proposals on business entities, it is obvious that this is going to be very different depending on the extent to which the business is affected by the measures which broaden the commercial income tax base. Certain of the measures are, for instance, targeted at specific industries (the insurance industry and Bausparkassen, a sort of savings-and-loan association). Commercial taxpayers engaged in activities not greatly affected by tax base expansion indeed have cause for elation, if the Petersberg Proposals ever become law.
A further fact to note is that, with a 25 % distribution rate on corporate dividends to non-resident shareholders, the tax burden on income earned in Germany will fall to under 38 % (assuming 17 % trade tax on earnings) on dividends to EU parent companies. And even with 5 % withholding tax the total burden would still be under 41 %.
Finally, we point out that the proposed revenue-generating measures pertaining to commercial businesses will lead to increased trade tax on earnings for the affected businesses.
8. THE POLITICAL OUTLOOK
It is rare in postwar Germany that fundamental change is legislated without broad support from all major parties. The German political system, which contains both parliamentary and federalist elements, is structurally inclined to consensus. It is at present very difficult to say whether the sort of consensus required to reshape the present tax structure will emerge or not. Talks have begun between the Government and the Opposition.
It should also be borne in mind that tax reform is but one of three fundamental economic policy decisions which Germany is facing. The other two are drafting a national budget which reflects the planned net decrease in income taxes of DM 30 billion and reforming the health insurance and social security systems. All three decisions will have enormous impact on both net disposable income for the working population and the cost of wage labour to employers. Regarding budget considerations, we point out that net tax reductions of DM 30 billion would have to be financed by increased borrowing, decreased spending, or some combination of the two. There is as yet no inkling as to how the Government proposes to solve this conundrum, and at whose expense.
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