The project is concerned with the central dimensions of neutrality in corporate- and capital income taxation. The question of whether taxes distort economic decisions is addressed. If tax neutrality is not achieved, the consequences for growth and employment associated with non-neutral taxation are investigated. Moreover, specific aspects of the German tax code, for example the 2008 introduced withholding tax on capital income, are evaluated with respect to neutrality considerations.
The project is structured as follows. In a first step, the central neutrality dimensions concerning corporate and capital income taxation are developed within a standard model for investment and saving. In a second step, starting from these neutrality dimensions, we evaluate the development of taxation from the situation before the 2001 corporate tax reform. After the institutional discussion, we empirically investigate whether tax neutrality is guaranteed by the German tax system. Finally, the aim is to evaluate the economic costs of non-neutral taxation in terms of growth and employment.
The most relevant taxation issue for an economy’s growth is the taxation of capital income, i.e. the tax burden on investment and savings, since it exerts potentially adverse effects on capital accumulation. In the context of a closed economy, there exist numerous neutrality postulations requiring that individual decisions should not be distorted by taxation. From a macroeconomic perspective, the true distortion of economic decisions depends on the effective burden of a tax. Therefore, the analysis is based on a general equilibrium model. For a closed economy, the model yields growth neutrality as the superior neutrality dimension affecting growth, in line with the well known result that an optimal tax system has to secure production efficiency. With respect to capital income taxation, this means that the tax rate on retained earnings has to be equal to the tax rate on interest earned, that investment-related value added has to remain untaxed, and that investment expenditures have to be fully exempt.
A calculation of the relevant tax wedges since 2000 shows that current regulations in 2009 lead to considerable violations of investment neutrality, although the effective tax burden has been reduced significantly in that period. The introduction of a withholding tax on capital income in 2009 has reduced the burden on debt financing of investors. At the same time, financing via retained earnings as well as equity financing are now subject to a higher tax burden for the investor.
However, in the context of a closed economy the tax effects on investment can only be judged to a limited extent. The simulation model of an open economy shows that the tax reform in 2008 with the introduction of the withholding tax on capital income leads to a shift in investors’ portfolios from company shares towards interest bearing corporate bonds. This relatively strong shift results in a weak growth effect of the decrease of the tax burden on investment. Further results of the simulation model show that capital is reallocated towards private companies. The effects on employment and growth are mildly positive. Alternative simulations assuming that company shares are mainly held as a form of substantial shares yield higher positive effects of the reform on employment and growth, as under this assumption the above mentioned shift in the portfolio structure does not take place. A comparison of the reform of 2008 to a fictional reform, which introduces a growth neutral tax system, demonstrates that there is still large scope for improvement. However, despite of strong growth and employment effects, the growth neutral system would lead to substantial losses in tax revenue.
In general, one must consider that the concept of growth neutrality is not entirely clear in the context of an open economy. To begin with, regulation in a single country cannot yield global production efficiency. Moreover, from the perspective of one country some neutrality violations in the global system may even be favourable. Taking into account various aspects of economic integration, the verdict on the reform 2008 turns out to be much more positive. This is, among other things, due to an increased attractiveness through a lower tax burden and to the divergence of domestic savings and investment.
An important recommendation resulting from the analysis is the abolishment of taxation of investment-related value added. Simulations suggest a long-term increase of investment of 8% and production growth of 3.4 % in this case. A positive side effect is that the debt ratio of corporations would fall significantly.
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