Why the German corporate tax reform is misguided

By: Sebastian Dullien, FT Deutschland and Eurozone Watch

Germany's corporate tax reform  is a prime – maybe the worst - example of the Grand Coalition’s inability to conduct sound economic policies. It also shows the weakness of the Social Democrats to defend their principles and the interest of their own constituency.
 

The reform plan is to lower corporate taxes by permanently €5bn a year, with higher revenue shortfalls in the first years. The idea is that German tax rates are not competitive internationally and a cut of effective tax rates (including both federal and local taxes) to below 30% would make Germany more attractive to foreign investors. As good as this may sound, there are a number of pitfalls in the proposals, which actually might lead to less rather than more investment in Germany.

 

The main economic problem of the reform is that - while it would lower tax rates - it would significantly tighten rules for depreciation of capital goods. Especially, the declining-balance method of depreciation will be abolished for good, which up to now allows companies to depreciate an above-average share of a new capital good in the first year after the purchase, giving investing companies more liquidity and some savings in financing costs. Economically, this means that companies with old machinery which do not invest anymore will profit from the tax reform, while companies which are investing a lot might even be faced with a higher tax bill.

 

Germany has made pretty bad experiences with reforms of that kind: In the last corporate tax reform in 2001, rates were also lowered significantly while depreciation allowances were cut. The result: In the global downturn from 2001 onwards, the share of private investment in GDP in Germany plunged much more than that in other eurozone countries. Before the reform, the German investment share was systematically about one percentage point higher than in the rest of EMU, after the reform, it lagged the rest of monetary union by an average of roughly two percentage points.

 

Facts like that are not much discussed in German politics at the moment. Employers’ federations speak out in favour of the reform package, even if the tool and machinery builders admit in private that they expect less (not more) domestic orders for capital goods after the reform. However, as the foreign business is more important to these companies than the domestic market, and profits from both sources will be more lightly taxed, they publicly support the reform.

 

While it is the good right of employers’ federation to fight for the biggest possible tax cut for the corporate sector regardless of its macroeconomic consequences, politicians really should ask themselves whether it is worth to cut taxes by €5-10bn  (critics claim that the latest figure is closer to reality than the ministry’s estimate of €5bn), if in the end, investment in Germany might be lower than without the reform. After all, real investments bring about a number of positive external effects: First, as we know from a number of empirically studies, investment is closely related to employment creation, which lowers the burden for unemployment compensation and thus social contributions. Second, as we know from New Growth Theory, fixed investment brings about positive external effects with regard to technological progress. The surge in productivity growth in the US over the past decade was at least partly a consequence of the strong investment activity of American companies in IT equipment.

 

One of the reasons for the misdesigned German corporate tax reform is the Grand Coalition’s way of designing reform projects: First, in a working group, “key points” of a reform project are agreed upon between Social Democrats and Christian Democrats, mostly giving the one party some say in one aspect and the other party some say in another aspect. In a second step, the ministries’ experts then try to write a law meeting these key points regardless whether they are compatible or whether the outcome meets any sensible economic or political goal. More often than not, the key points together really do not make sense and thus lead to a completely misguided policy bill. This was the case with the health reform proposal as well as with the corporate tax reform.

 

The key-points for the corporate tax reform contained two targets which were very hard to bring together: The idea of lowering the effective tax rate below 30% and the political aim of not cutting the corporate tax burden by more than €5bn over the medium term. As the rate cut by almost 10 percentage points would have been much more expensive than €5bn, politicians resorted to cut back on depreciation allowances and other tax breaks for companies, regardless of economic consequences.

 

This concept was helped by an anti-economic approach of many German politicians to tax policy: In Germany, there has been some frenzy about simple taxes with a broad base and low rates, often brought forward by people with an education in law, not economics. These lawyers often define unnecessary tax breaks very widely: Paul Kirchhof, once supreme court judge and later conservative candidate for the position of a finance minister, proposed to replace economic depreciation in the tax code by technical depreciation. In other words: Companies would only be allowed to deduct the costs of some new piece of equipment over a period of time which is equal to its average technical life span. (Today, what matters both for general accounting purposes as well as the tax code is the economic life span). Under Kirchhof’s rules, companies would still be writing off the value of their typewriters purchased in the 1980s, as these pieces of equipment still technically work (even though they do not have any value in the production process anymore). Behind this approach was the (ideological) idea that the tax code was not supposed to change the people’s or companies’ behaviour, even if the change in their behaviour would increase overall national welfare. Needless to say, advocates of broadening the tax base while cutting exemptions, also applaud the idea of cutting the declining-balance depreciation and lower tax rates.

 

What is even more startling is the fact, that especially the leadership of the Social Democrats pushes forward the tax reform. As the project has been constructed by their ministry of finance, Peer Steinbrück, they try to avoid any real debate about the reform. Arguments that the reform might lead to less, not more fixed investment in Germany is meet with a shrug as well as the argument from the political left that the reform shifts the burden of taxation further into the direction of wage-earners. This shows that the Social Democrates in their current state are neither able to construct sound economic policies nor to be an effective representation for their own clientele.

 

Unpopular as the corporate tax reform is both with the SPD electorate and the party members, the way the party leadership pushes forward this reform might be a further element in the decline of the Social Democrats, cementing the SPD’s position as a party with an electoral share of less than 30%, which will only be able to form a coalition as a junior partner of the Christian Democrats.

 

The course of the Social Democrats is even less understandable as it violates their own stated principles. In their draft for their basic program, it reads: “We want to end the race in Europe towards the lowest rates of corporate taxes, by which European states destroy their own capacity to act.” Now, the German Social Democrats are the driving force behind pushing the German effective corporate tax rate below those in France, Italy, Spain and Belgium. While so far, tax competition was mainly waged by small countries, Germany is the first large country to join the game. Its neighbours cannot afford to ignore this challenge. You do not need much imagination to predict that in only five years from now the debate in Germany will again be about lowering the effective tax rate – that time then with the target of getting the rate below 20%.

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