In the wake of the recent passing of major reforms to US tax laws, the European Union and Germany urgently need to discuss the implications of the new measures for their own tax system.
Beyond the income tax changes, the reform reduces the tax burden on corporate profits and, importantly, puts in place a 100% expensing rule for capital investments. As a result, the US will likely become more attractive as a place to invest and do business.
A first indication of the tax reform’s effects has been Apple’s recent announcement to plan a new “campus” in the US and accelerate investments. Moreover, the tax reform will increase the deficit of the United States in a pro-cyclical way, which may further increase the current account deficit of the US.
The European Union’s first and most immediate concern with these reforms should be that of tax competition. Here we are touching upon a politically very sensitive topic; popular opinion is certainly very concerned by tax competition and the perceived shift of tax revenues away from corporate taxes to labour taxes.
One widespread political concern in Europe is that the Trump administration’s move will accelerate the race to the bottom on corporate tax rates and increase pressure in Europe to follow suit – with consequences for the financing of the relatively large European welfare state. This concern is particularly pronounced in France, which has a relatively high corporate tax rate. France has been strongly pushing the policy debate on achieving a more harmonised European corporate tax setting that would prevent a further race to the bottom in tax rates.
A second important consideration relates to the impact of the US tax reform on current accounts. To start with, the US current account deficit could, at least initially, increase due to the increased fiscal deficit. Moreover, the gain in the relative attractiveness for investment in the US – as compared to Europe and Germany – could pull corporate investments away from Europe towards the US.
A combination of tax exemptions for domestic investment and a number of supply-side reforms would trigger a new and sustainable domestic boom in Germany
The latter point should be of particular concern to the incoming German government. Germany currently has the largest current account surplus in the world, amounting to around 8% of GDP. From the beginning of monetary union – when Germany’s current account surplus was in slight deficit – through to the present, the move towards greater surplus has primarily been driven by increasing savings and falling investments in the German corporate sector. In particular the low corporate investment in Germany has led to a stagnation of the German capital stock. Germany’s capital production intensity has fallen relative to that of the United States.
On a political level, Germany has been singled out by the US president for its large bilateral trade surplus with the US. While the bilateral trade measure is not an economically useful measure, it does influence political perceptions in the US. But also organisations such as the IMF have been pointing to the fact that Germany’s current account surplus reflects an excess in corporate savings, relative to a weakness in corporate investment, which is undermining prospects for growth in Germany and is ultimately not in Germany’s interest.
In these circumstances, it would be useful for the German policy establishment to have a serious conversation on German corporate tax reform. The coalition agreement puts a strong focus on reducing tax competition in the European Union by suggesting a collaboration with France on a common consolidated tax base and minimum tax rates. Neither Germany nor France wants to engage in a race to the bottom on corporate tax revenue, as they want to preserve a strong social model and a relatively large government sector.
Still, this approach does not provide an answer to the strategic challenge posed by the US tax reform and its impact on investment in Germany. The German debate should add a focus on depreciation allowances for capital investment, and for research and innovation investment. Such a tax reform would provide strong incentives for the German companies that currently hold large amounts of cash to invest in Germany.
Rather than holding their savings in short-term assets with relatively low returns outside of Germany, a combination of tax exemptions for domestic investment and a number of supply-side reforms would trigger a new and sustainable domestic boom in Germany. This policy would not only be good in bringing down Germany’s current account surplus, it would also be helpful in further boosting salaries in Germany that have suffered partly from the weak development in German capital stock.
The new government should address the challenge posed by US corporate tax reform head on. A sensible response would be to incentivise corporate investments while cooperating with France on the tax base and the tax rates.