Race to the bottom Why Germany must react to Trump’s tax reform

America's tax cuts put Berlin under pressure to reduce the burden on corporations, in order to defend its global competitiveness.
Germany seeks a taxing response.

Donald Trump started the year with a bang – for the buck. Income taxes were cut sharply and the tax rate for corporate profits fell to 21 from 35 percent. Under this sweeping reform, the US president aims to lure companies to invest more in the US and report a larger part of their global profits there.

In Germany, the revamp of US tax rates has caused a wringing of hands, and rightly so. It has been a decade since the last major change in German corporate taxes, and since then, our tax policy has been in a deep slumber. Since Germany’s economy has perked up, politicians haven't thought it necessary to re-examine the tax code for improvement.

In Germany, tax on corporate earnings amounts to 15.8 percent including the so-called solidarity surcharge to fund reunification. But that’s not including local trade taxes, which have risen sharply in recent years and now amount to 14 percent. Add that to the corporate rates and Germany’s total tax burden for corporations is, on average, 30 percent. But in big cities like Munich, where local trade taxes are higher, the figure can rise to 33 percent.

Since the last major change in German corporate tax, our policy has been in a deep slumber.

Given the changes in the US, the question is how Germany can remain competitive in the global tax landscape. Last year, France and Belgium both had higher tax rates than Germany’s, at 34 percent. In the meantime, however, both countries have decided to cut taxes. France will gradually reduce the corporate tax rate to 25 percent by 2022, and Belgium to 25 percent by 2020. Other countries in Europe are becoming even more aggressive: Britain, for example, wants to reduce the tax rate from 20 percent today to 17 percent by 2021.

If Germany does not act, its tax burden will soon be the highest among leading industrialized countries. This would prompt companies to move profitable investments and jobs abroad. Special tax arrangements for companies would help them shift profits abroad and claim costs against profits back in Germany. Studies show that a tax rate difference of 10 percentage points with other countries causes a migration of around eight percent of profits reported in Germany.

So what should German policy-makers do? The ruling coalition says it favors setting a lower limit for corporate tax in the EU, something that could trigger tax increases across Europe. Instead, we Europeans should cut our own tax rates and take steps to prevent companies shifting profits abroad in order to avoid taxation.

In Germany, there is the illusion that other countries wouldn’t reduce their taxes if Germany were to stand still.

The European level, however, isn’t the right place to forge a response to America’s tax reform. Tax policy decisions require unanimous agreement among EU members, and if reforms come about at all, their preparation often takes years.

First of all, Germany needs its own tax strategy, which could be developed in consultation with France. Emmanuel Macron’s government has taken a sensible line by agreeing a gradual and moderate tax reduction to 25 per cent. Berlin should follow suit and reduce corporation tax from 15 to 10 percent. Combined with local trade taxes, Germany’s total tax burden would amount to 25 percent.

Moreover, politicians must not forget that business partnerships are of great economic importance in Germany. These companies can transfer retained profits into a so-called retained earnings reserve and pay tax at 28.25 percent. But dividends paid to shareholders are also taxed. The upshot is, business partnerships have a tax burden that’s similar to that of corporations. So it would make sense to reduce taxation in the retained earnings bracket to 25 percent.

In Germany, there is a widespread belief that cutting taxes at home would fuel an international tax competition. That view, however, is based on the illusion that other countries wouldn’t reduce their taxes if Germany were to stand still. That, clearly, is not the case. Obviously, Germany's passive stance in recent years has not deterred the US, France or the UK from easing their own taxes.

The fact is, Germany is simply too small to have a significant influence on global tax policy. But doing nothing, and watching profits and investments migrate abroad, would do us much more harm than good.

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