«Kiel Working Paper No. 1196 Germany’s Fiscal Policy Stance by Horst Siebert January 2004 The responsibility for the contents of the working papers ...»
However, only half of his dividend income is subjected to the personal income tax rate, the argument being that the income was already taxed at the firm level (half-income approach or Halbeinkünfteverfahren). Prior to the tax reform, the capital owner could deduct the corporate income tax already paid by the firm from his income tax liability (credit approach or Anrechnungsverfahren).
Therefore the reduction in the tax rate of the firms does not mean a similar reduction for the capital owner. The smaller and medium sized firms complain that the tax reform favors larger firms. As long as they keep profits as retained earnings, the earnings effectively have a lower tax rate for the capital supplier than dividends. Indeed, the tax is not neutral with respect to the legal forms of enterprises. However, the person who provides capital is taxed at about the same
effective rate independently of whether he invests in his own firm or in a publicly traded company.
To apply different tax rates to the enterprises and to persons, as is the case in Germany now, requires a clear separation of the tax base for the enterprise sector from the tax base of individuals. In the case of owner- firms, many details in the taxation laws have to be specified to delineate the two areas. In the case of incorporated firms, the more favorable tax rate for firms requires some type of additional taxation when ownership titles are sold. This would mean that a capital gains tax becomes necessary in such a system at least when the equity titles are sold.
On a more fundamental aspect, there are two different concepts for an income tax system (German Council of Economic Advisers 2003). According to the concept of a synthetic income tax, all types of income are subject to the same tax rate. This avoids delineation issues. Admittedly, the German system has become inconsistent due to many exemptions. One line of reform therefore is a simplified tax system where exemptions are abolished and where the tax rates come down. This has been accentuated in 2003 by the Merz proposal of the Christian Democrats; similar proposals have been presented by the Council of Economic Advisers in the annual reports of the 1990s, the Bareis Commission, the previous constitutional court judge Kirchhoff, the Petersberger Beschlüsse of the Christian Democrats and by the Liberal Democrats.
According to an alternative approach, a distinction should be made between taxing capital income (enterprise sector, dividends and interest) and other labor income (dual income tax). Since capital is mobile internationally, a lower rate should be applied to capital income as in the Scandinavian approach. This concept, for which the German Council of Economic Advisers has expressed 13 sympathy in its Annual Report 2003/2004, has to solve the delineation issue for the multitude of firms between the enterprise sector and the individual area. It is likely to imply bureaucratic decisions. This is a specific problem with respect to the Mittelstand. The approach may also lend itself to a more active and interventionist role of the government defining income taxation from its functionality instead of starting from the premise that the state’s infringement on the individual’s maneuvering space and his liberty should be limited.
Governmental financial support to firms and households plays an important role in the German economy. Subsidies can be explicit transfer payments or they can come in the form of tax breaks. In a narrow interpretation used in macroeconomic accounting, subsidies are transfers to producers. This delineation would exclude transfers to households and to targeted groups of society, which constitute an important element of governmental transfers in a social market economy. It would also exclude transfers to semi-public service suppliers or tax breaks for them, such as the supply of community heating by municipal suppliers or the operation of museums. I therefore apply the wider definition as used by the Kiel Institute for World Economics including these aspects (Boss and Rosenschon 2002). Subsidies then are defined as financial support or tax breaks that affect the allocation of resources. They account for 156 bill euro per year in 2001, which equals 7.5 per cent of GDP or 35 per cent of total tax revenue.
Subsidies include sector specific subsidies (86 bill euro) for agriculture, for coal mining, for transportation, especially for the public transport system, for housing and subsidies to firms in general such as in regional and structural policy and 14 employment policy (Table 4). Subsides also include transfers to specific groups like housing allowance for low-income groups, but they do not include funds spent for the general function of the state, such as providing funds for poverty relief or the financial flows of the government to schools, universities and to research organizations like the Max Planck institutes. Subsidies come from the three layers of government, the Federal Labor Office and from the European Union.
15 Table 4: Subsidies in bill euro, 2001
Source: Boss and Rosenschon (2002), Tables 5 and 6.
The political compromise between the government and the Bundesrat in December 2003 in order to move up part of the tax reduction by one year brought the reduction of two subsidies, the support for families to build a house and the tax allowance for commuters to the job, which incidentally only had 16 been expanded in 1990 by the Red-Green government. Subsidies to the coal industry were supposed to end in 2005. In November 2003, however, the Chancellor promised a continuation of the subsidies until 2012 with a total volume of 16 bill euro for the whole period. In principle, this violates the EU’ s code on state aid. But in a compromise with the European partners, Germany secured the votes of some EU countries and obtained the permission of the EU Council to continue the coal subsidies. In return, it had agreed that they could go on with their preferential treatment of their trucking industry. Thus, besides the taxpayer, German truckers pay the price for the coal subsidies.
This identification of subsidies does not include all types of state aids. The reason is that the calculation is simply too difficult. For instance, the bail-out obligation of municipalities and the federal states vis-à-vis the savings banks and the federal states banks are not factored in. Another aspect left out is that the electricity distributors are forced to purchase the electricity produced from wind mills at an artificially high price. Involvement of government in terms of equity where the state renounces receiving a normal rate of return is not counted either.
Subsides create large opportunity costs. These costs stem from a heavier tax burden, which reduces the effort of workers and entrepreneurs and negatively affects labor supply and demand as well as investment. Traditionally, inefficient or less productive sectors receive the state aid, so that overall productivity is reduced. As a result, new sectors are hurt, and allocation is distorted. Firms engage in rent seeking as they attempt to receive favorable treatment instead of competing in the market place. Once an economy gets used to subsidies, it is difficult for the politician to say “no” when a firm, a sector or a whole region finds itself in trouble. Moreover, subsidies are one reason for a high share of government in GDP, which has a negative impact on growth once a certain threshold is surpassed. Germany has had a discussion from time to time on 17 cutting subsidies, either in a lawnmower approach by reducing all the subsidies by an equal percentage or by getting rid of specific subsidies. At the same time, new subsidies, for instance for windmills or for the cogeneration of electric power and heat.
Distributional Elements in the Budget Germany’s fiscal policy traditionally has a distributive role, besides the function of allocation, i.e. of providing public goods. A large part of the government expenditures is absorbed for social purposes. Analyzing governmental expenditures by function, 42 per cent of the expenditures of the federal government (102 bill euro out of 243 bill euro in 2001) are for social purposes according to the official classification of the government. This includes among others the transfers to the social security system - one fifth of the expenditures of the systems of social security comes from tax revenue (see below) -, unemployment benefits of type II, social policy for farmers, education allowances (Erziehungsgeld) and maternity benefits (Mutterschutz) and payments for war victims and their widows. There are additional expenditures that are not included in the social expenditures but that do have a social dimension such as expenditures in education for pupils and students (0.7 bill euro), the support of housing (1.8 bill euro) and subsidies for the coal industry (3.6 bill euro).
The effect of the governments activity on the distribution of income can be seen by comparing the Gini coefficients for the income distribution before and after taxation and governmental transfers. For the households surveyed in the Socioeconomic Panel (Council of Economic Advisers 2003:349), this coefficient is reduced considerably when comparing the market income distribution with the 18
Source: German Council of Economic Advisers (2002: 350).
The Impact of German Unification For the transformation of the previously centrally-planned economy in Eastern Germany quite sizable transfers were needed. The magnitude of these transfers, however, is difficult to calculate. The last somewhat official estimate of the transfers was undertaken by the German Council of Economic Advisers (Table 7 40, 1995). The Council distinguished gross or consolidated transfers of the different layers of the state and net transfers. The net transfers were defined by consolidating the transfers of the different layers, i.e. eliminating double
counting, and by taking into account governmental revenue such as tax revenue in the new states. For 1995, the gross transfers including interest payments and repayment of debt directly associated with unification were estimated at 108 bill euro; net transfers amounted to 82 bill euro or, neglecting interest and 8 repayment of debt, to 64 bill euro. This was 4.6 per cent (unconsolidated between the different layers of government) or 3.6 per cent of the German GDP (consolidated, i.e. without doubling counting) respectively. Of these two, the consolidated figure is the relevant one.
Of the gross transfers of 108 bill euro, 28 per cent went to the public sector, i.e.
to the budgets of the new Länder, 22 per cent were provided by the public budgets to private households and 26 per cent went to households through the social security system. Of the transfers to households, 14.6 bill euro flowed to East German households in the pension system; 12 bill euro were transmitted within the unemployment insurance. Unfortunately, only a small part of all the transfers, about a quarter, was used for investment, while the overwhelming part represented and still represents transfers for consumptive purposes including government consumption. This holds true not only for the transfers within the social security systems, but also applies largely to transfers between the layers of government, for instance for paying the over-manned administration in East Germany.
Transfers still go into Eastern Germany, but for a variety of reasons we do not have sufficient data on their magnitude. First, we no longer have a separate macroeconomic accounting for the expenditure side of East German GDP; the last separate status was for the year 1994. Such accounts, however, would make it possible to calculate a balance of payments with the current account deficit for East Germany and thus determine the real resource flow. Second, one cannot
8 The original figure is 4.7; GDP was revised downward. 20
simply interpret spending of the federal level in East Germany for governmental purposes as transfers, such as the transportation infrastructure or the army, because the federal government spends funds for the same purpose in West Germany as well. Therefore, one would need a norm from which to calculate spending above the norm. Third, the mobility of people, including commuting, makes it more difficult to calculate financial flows to East Germany. For instance commuters pay contributions to the social security system in West Germany, and people do their shopping and pay the value added tax in both parts of the country. Fourth, the regional delineation is complex. With respect to Berlin, only East Berlin belonged to the former German Democratic Republic, but, of course, we do not have separate data for East Berlin. What is more important, it makes little sense in a problem-solving approach to look at the East German region without Berlin. There was also little interest among the political elites emphasizing the transfer concept for fear that East Germans felt they would not get enough and that West Germans believed they paid too much to finance the transfer. Such a debate would be a source of quarrel instead of bringing the people together.
One can argue that the size of transfers has decreased since 1995. There has been economic growth in East Germany, and the tax base has enlarged. With a higher personal income, more contributions were paid into the social security system. Unemployment, though still high, has receded. Governmental programs for the unemployed were scaled down considerably. Specific investment subsidies for the private sector were discontinued so that only the same regional support scheme applies as in West Germany, albeit with higher flows to East Germany due to the lower level of GDP per capita there.