Proposal for a Tax Policy Reform Program in Germany: for Simplicity, Fair Distribution of Burden and More Competitiveness

Tasks

Over the past ten years, German tax policy has shown little willingness to reform. Changes have largely been limited to marginal adjustments and reactions to court decisions. At the same time, criticism of the tax and transfer system raised in public and political debate. On the one hand, the discussions focus on redistribution aspects and the question of fair distribution and burden sharing. On the other hand, there are calls to improve the competitiveness of the German tax system and Germany as a business location.

The ifo study Tax Reforms for Simplicity, Fair Distribution of Burden and More Competitiveness makes transparent the trade-off problems of a post-crisis tax reform that exist between the goals of strengthening competitiveness and performance incentives, simplifying the tax system and fair distribution and burden sharing. It also identifies options to reconcile these objectives. The main focus is on developing a tax policy reform program for Germany, within which pragmatic solutions to some of the most relevant issues concerning the future of the tax and transfer system are proposed. Some of the questions in focus are: 

• How can the tax and transfer system be reformed so that work and performance incentives are strengthened? 
• What does a fair distribution of the tax burden look like? 
• Can and should wealth-based taxes play a greater role in financing public spending and consolidating debt in the future? 
• How can investment and innovation incentives for companies be strengthened? What role can tax incentives for research play in this context?
• And many more.

Methods

For developing a comprehensive tax policy reform program, an analysis and synthesis of evidence from existing ifo studies/preliminary work and external publications was conducted. Further subprojects were conducted, which themselves provide relevant information as input for the reform program. 

In addition, relevant simulation models are used to quantify the effects of tax policy reform options. Central here are a data-based dynamic CGE simulation model for simulating macroeconomic effects and tax revenues (Stimmelmayr 2007, Radulescu and Stimmelmayr 2010), as well as the ifo microsimulation model (ifo-MSM-TTL, ifo Tax and Transfer Behavioral Microsimulation Model) for taxes and transfers in Germany (Blömer and Peichl 2020).

Data and other sources

Blömer M. J. und A. Peichl (2020). The ifo Tax and Transfer Behavioral Microsimulation Model, ifo Working Paper No. 335.

Radulescu, D. und M. Stimmelmayr (2010). The Impact of the 2008 German Corporate Tax Reform: A Dynamic CGE Analysis, Economic Modelling 27, 454–467.

Stimmelmayr, M. (2007), Fundamental Capital Income Tax Reforms: Discussion and Simulation Using ifoMOD, Beiträge zur Finanzwissenschaft 23, Mohr Siebeck, Tübingen.

Results

How can more incentives for employment and more tax relief for families be achieved by reforming the tax and transfer system? 

The ifo study presents a reform proposal for the income tax and transfer system that is almost revenue-neutral for the government budget (Blömer et al. 2021). The reform variant, which was simulated with the ifo microsimulation model (ifo-MSM-TTL), increases tax incentives to participate in the labor market and distributes the burden fairly by focusing more on children in the tax benefits for marriage and family. In addition, there would be more winners than losers in all income deciles. The middle class would have the largest income gains in this tax policy reform proposal. Among the biggest winners would be higher-income households with children. Couples without children and with high income disparity would have to pay more taxes on average than before. The efficiency gains of the reform would lead to nearly 400,000 more employees (FTEs) or an increase in labor market participation of up to 275,000 employed persons in Germany.

How do tax cuts affect economic development and tax revenues in Germany?

Using a data-based dynamic simulation model (CGE model), the effects of various tax reform options on tax revenue and other economic variables were examined (Dorn et al. 2021). A reduction in the corporate income tax by 5 percentage points leads in the short term to a drop in tax revenue of 13.8 billion euros. In the long run, the annual tax losses are smaller because investment and employment increase. A combination of a corporate tax cut and accelerated depreciation would reduce tax revenue by as much as EUR 30 billion in the short term. On the other hand, investment and employment would increase so strongly that annual tax revenues would return to their original level in the medium term. However, gross domestic product and private household consumption would be around 3% higher than without reform. Wages would be about 4% higher. Income tax increases (top tax rate) and an increase in the sales tax are also considered. Financing public spending through sales tax has fewer negative effects on investment, employment, and consequently overall economic development than financing through income taxes. This points to the classical trade-off between distributional and efficiency goals in tax policy.

How can taxes promote innovation incentives?

Innovations form the basis for technical progress and have a decisive influence on the future viability of economies. However, positive externalities as well as the inherent risk of investments in research and development (R&D) lead to private sector investments in R&D being below the efficient level in the market equilibrium. The state can compensate for this market failure by providing targeted incentives for innovation. Various tax policy instruments are available for this purpose: A distinction is made between targeted fiscal R&D support (input- or output-based) and general fiscal support via corporate and income taxation. In an evidence report with meta-analysis, the existing literature on the effect of fiscal R&D support was systematically evaluated (Falck et al. 2021). The analysis shows a predominantly positive effectiveness of fiscal R&D support. Targeted, input-based fiscal R&D support and general support through corporate taxes show a positive effect on innovations and R&D activities in private-sector companies.