Tax Policy for Economic Growth
The German Economy has contracted for two years in a row, and corporate investments are behind those of other European nations. Business confidence is low and economic outlooks remain pessimistic. In this context, policymakers are deciding how to taxA Tax is a mandatory payment collected by local, State, and National governments from individuals and businesses to cover the cost of general government goods, services, and activities.
This article provides reflections on this debate.Observation 1
In recent years, Germany has become less attractive to business investors, as evidenced by rankings such as the IMD World Competitiveness Index. This article provides reflections on this debate.
Observation 1
In recent years, Germany has become less attractive to business investors, as evidenced by rankings such as the IMD World Competitiveness Index. The country is facing deep-rooted structural issues that need attention. While short-term investment incentives and tax subsidies may provide temporary relief, they cannot substitute for the long-term structural changes needed to restore Germany’s competitiveness.
The German economy faces numerous structural challenges, including high energy prices, emerging trade frictions, excessive red tape, sluggish bureaucratic processes, a shrinking working-age population, and deteriorating public infrastructure. To address these challenges, it is necessary to tackle their root causes instead of just treating the symptoms. Quick fixes, such as tax incentives and investment incentives, are unlikely to produce sustainable results. Firms don’t base their investment decisions upon short-term subsidies and tax benefits lasting only a year or so. They invest with an eye on medium- to long-term profitability. Investment decisions are largely influenced by the expectations of firms about the future economic and political environment. Germany must address the underlying issues to attract and retain businesses and investments. The corporate tax rate in Germany is among the highest in the world. Reducing it would enhance the country’s attractiveness to mobile international investments.
Companies in Germany face a statutory corporate tax rate of approximately 30 percent. This rate is higher than in most other Western economies, lowering Germany’s ability to attract internationally mobile and often highly profitable firms.
When highly productive businesses decide whether to locate a new plant or department in Germany or elsewhere, the prime measure of interest is the statutory tax rate, while deductions and
depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Depreciation is a method of determining the period over which taxable income can be deducted from the cost of an asset, such as machinery or a factory.
The regulations are of less relevance. The latter provisions, however, do influence marginal investment activity.The corporate tax rate is high, which puts Germany at a disadvantage in the race to attract mobile, productive companies and the high-quality employment they bring. In recent years, this challenge has grown more pronounced as unilateral and multinational actions have restricted multinational firms’ abilities to lower their effective taxes through international tax planning. High corporate tax rates today are likely to deter economic activity more than just trigger
profit shift. Profit shifting is when multinational firms reduce their tax burdens by moving their profits from high tax countries to low tax jurisdictions and tax hashes.
–with arguably more detrimental effects on national economies.Observation 3
Tax deductions and investment premia mainly foster investment of SMEs.
Generous tax deductions can play a positive role too. When firms are able to deduct investment costs faster, their
taxable IncomeTaxable Income is the amount of income that is subject to tax after deductions and exclusions. Taxable income is lower for both individuals and corporations.
can be reduced earlier, deferring the tax payment to future periods. The taxpayers benefit from both an interest effect (where deferred taxes payments reduce the current value of tax liabilities) and a liquidity impact, as firms retain a greater cash flow on the short-term. In line with this strategy, the outgoing German government proposed more generous tax deductions on fixed assets acquired over the next few years. However, the legislative proposal did not pass parliament before the breakup of the three-party coalition.Reforms along these lines are unlikely to be a game-changer for investments of large and financially unconstrained multinational firms. Empirical evidence, however, suggests that smaller and medium-sized businesses (SMEs)–particularly if they are liquidity-constrained–show sizeable investment responses to this type of policy. Fiscally, the measures are attractive because fiscal costs tend to be small, reflecting that revenue is merely deferred to future periods.
Much-discussed investment premia are related to tax depreciation allowances in that they target investment activity directly, thus limiting windfall gains. Investment premia, unlike tax deductions, which defer tax payments, reduce the net burden of companies and benefit loss-making businesses. The concept of a coexistence between high corporate tax burdens and investment premia is generally unappealing, and it involves administrative burdens.
Observation: 4
Innovation plays a major role in determining growth. R&D tax incentives play a key role in encouraging corporate innovation.
Innovation plays a major role in economic growth. Research shows that R&D investment has a much higher return on investment than the initial costs. Germany is still ranked high in international innovation rankings (due to the well-trained workforce and other factors), but challenges remain. Many of these are outside of the tax realm, including regulatory constraints and a lack of access to finance.
Taxes can play a role in fostering innovation too. Germany, one of the few European and OECD nations to introduce such a policy in 2020, introduced a R&D tax incentive. Since then, the credit rates and funding limit have been increased. Although conclusive evidence of the effect on German companies is still lacking, other countries’ experiences show that R&D incentives increase innovative activity. Research has shown that R&D tax incentive spending is associated with increased R&D output such as patents and positive knowledge spillovers for society. Despite these challenges, they still need to be addressed. Survey evidence, for example, suggests that there is scope to improve take-up of the scheme by German firms, such as through information campaigns and facilitated administration.
Moreover, it would be beneficial to expand restrictive loss offsets provisions in the German tax code. This would make the code more neutral for investments that have variable income paths, such as R&D, which has losses during the development stage but only positive incomes in later years. Enhancing the treatment of losses in Germany would avoid discrimination against these types of investments.
How to Finance the Tax Cuts
Tax cuts need to be financed. The tax cuts must be financed. At a time of high government spending, it is not easy to adjust the budget in order to accommodate such reforms. Germany must invest more in military expenditures to meet NATO commitments and to deal with new geopolitical threats. Special funds allocated for this task are soon to expire. There is also a need to increase spending on public infrastructure. These longer-term needs limit the ability to match tax cuts by reducing public spending. There is still room for improvement: the German budget includes a number well-known subsidies that are perceived to be ineffective. In general, strengthening public investments over public consumption would be desirable, for example, by abolishing questionable social spending programs that are not well-targeted to individuals with low incomes and poor health (like early retirement schemes
).[“Rente mit 63”]Germany is bound by a constitutional brake on government debt, which limits options to finance tax breaks by debt. The fate of the debt brake is still unclear. Several parties are currently advocating reforms to ease public borrowing. Tax increases are the only remaining source of funding. Taxes that are less economically distorting, such as raising the rate of value-added taxes from a relatively low level in comparison to other European countries, could make up for the lost revenue. This would increase the efficiency of the system by generating more revenue through less distorting taxes. However, the regressive character of consumption taxation could raise equity concerns. These concerns could be addressed in two ways by policymakers. First, they can emphasize that corporate tax reductions create well-paying employment and income opportunities for workers across the entire income distribution. In practice, the effects of corporate tax reforms are partially passed on to consumers and workers through higher wages. Second, corporate tax reforms can be combined with other reforms to increase the progressiveness of the tax system, without too high efficiency costs, like a strengthening of inheritance taxation. Corporate tax reductions are part of the strategy. Germany’s corporate tax burden is high compared to other countries. In the latest version of IMD’s World Competitiveness Ranking in the area taxation, Germany ranks 62nd of 67. Bringing down corporate taxes would be an important signal to investors–and it would improve locational attractiveness instantaneously, contrary to many other priority areas of government action, like improvements in infrastructure and cutting red tape, which take longer to bear fruit.
Note
: This blog post is part of a series focused on the impacts of tax policy and the 2025 German federal election. See more here, here, and here.
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