Do tax cuts really end up financing themselves?

In their election program, the FDP advocates far-reaching tax cuts - even if that initially raises debt rates. In our Short Cut series on the Bundestag elections, we discussed the points of debate surrounding this proposal with Christian Dürr and Rüdiger Bachmann.

 

The contribution is part of our New Economy Short Cut series for the Bundestag elections, in which we invite prominent candidates to discuss their parties’ ideas on the major economic issues of our time. Other panellists are Norbert Walter-Borjans (SPD), Caren Lay, deputy parliamentary group leader of the party the Linke and Anja Hajduk (Bündnis 90/ Die Grünen). The programme at a glance.

After the financial crisis, the debate among economists about the effects of fiscal policy has received increased attention and led to a rethinking in some political circles. As a “minimum consensus”, the view seems to have prevailed that an exceptional situation such as a global economic crisis, a natural disaster or pandemic justifies a temporary increase in debt. There is also a fundamental consensus that the effect of fiscal policy on economic development, the fiscal multipliers, strongly depend on the respective context.

From an economic point of view, does it make sense in the current situation to reduce the tax burden on German companies and high-income earners to the extent proposed by the FDP? What does the existing empirical research say about fiscal multipliers? Is it already possible to draw valid conclusions from the last US tax reform? We were able to discuss some of the possible implications of tax cuts with Christian Dürr (Member of German Bundestag from the FDP) and Rüdiger Bachmann (Professor of Economics at University of Notre Dame, USA).

The whole session as a re-live here:

The main takeaways

A key point of the exchange between Christian Dürr (FDP) and Rudi Bachmann (University of Notre Dame, USA) was the question whether the tax cuts proposed by FDP would pay for themselves. Assessments differed on this question until the very end. Based on the recent study undertaken by ifo Institute, Christian Dürr argued that increased investment activity would compensate for lower tax revenues over about a decade. Rudi Bachmann objected that these calculations were very optimistic.

The economics professor began by giving a short overview of the research on the topic. According to Bachmann, the empirical literature shows a very mixed picture with large divergence in the measured effects and high standard errors. He added that the meta-analysis by the Vienna Institute for International Economic Studies had also pointed to a possible publication bias in this research field. Although there is positive evidence that investment activity and GDP are stimulated by tax cuts, the transmission mechanisms on the labour market, for example, are less clear. This can be seen not least in the example of the last US tax reform, which did not lead to higher real wages. Rudi Bachmann also noted that Germany is a much more export-dependent economy, which is why the effects could be smaller than expected. In view of long-term trends towards a high propensity of companies to save and to a secular stagnation of the economy, he sees it as rather unlikely that the fiscal multiplier effects will be realised to the extent desired by the FDP.

 

Christian Dürr emphasized that his party does not see tax cuts as an end in itself, but as a central vehicle to promote investment and growth. Since the private sector must bear the lion’s share of the investments in the digital and green transformation of the economy, politics must set the course by reducing bureaucracy and creating favourable political framework conditions. In addition, he said, stronger promotion of immigration and more free trade were also important to secure economic growth in Germany.

 

Rudi Bachmann took the view that the major challenges of decarbonisation and digitalisation require more state spending. The FDP parliamentary group vice-chairman only partially agreed with him on this point: although the state should specifically promote the path to “green growth” in some key sectors, such as the hydrogen economy, subsidies are often the wrong approach (e.g., for e-cars). Christian Dürr spoke passionately in favour of market-based instruments in C02 emissions trading (i.e., in favour of quantity limitation versus carbon pricing).

There was agreement on some specific points, as the potential of accelerated depreciation and the automatic stabilising effect of a negative profit tax were emphasised by both interlocutors. However, the key point of the discussion, whether the FDP election programme was compatible with the debt brake, remained an open question. According to Christian Dürr, a time-stretched implementation of his party’s tax plans guarantees sufficient leeway to remain in line with the debt brake. In addition, he said, the federal budget offered potential for cuts. Rudi Bachmann believed politics should always come up with a “plan B” in case of a less favourable economic development.

 

What else was important?

On the topic of income tax, Christian Dürr pointed out that it is not only the tariff that needs to be considered, but also the tax incidence. In this context, he referred to the study by Fuest et al 2017, which shows that, in Germany, more than half of the corporate tax burden is transferred to employees. In his view, it is necessary to relieve the tax burden on the middle class.

Furthermore, Rudi Bachmann mentioned that there were good economic arguments for making greater use of the inheritance tax, whereas Christian Dürr represented his party’s position rejecting increased taxation on assets.

 

The political debate

In the opinion of the Free Democrats, a “budgetary turnaround” is necessary in the wake of the Corona pandemic. While the SPD, the Greens, and the party the Linke tend to advocate for more redistribution in their election programmes, the FDP and the CDU/CSU rule out tax increases after the Bundestag elections and call for an “unleashing” of the German economy. In this context, the FDP election programme provides for the strongest tax relief, both in income tax and in corporate taxation. The Free Democrats call for reducing the average tax burden for companies to below 25%, which is to be achieved by, among other things, abolishing the trade tax, lowering the corporate income tax from 15% to 10% and simplifying possibilities for depreciation. In addition, tax cuts and the abolition of the solidarity surcharge are proposed for all income brackets, whereby top earners and the wealthy could book the most significant savings compared to the tax plans of other parties. All these measures are supposed to bring tax relief for private households (approx. 45 billion euros) and companies (approx. 30 billion euros). [1]

According to the FDP, these tax breaks are not only compatible with the debt brake, but necessary for its long-term compliance. Only by focusing on investment incentives now could the German economy boost growth and the country “grow out” of the debts taken on during the Corona crisis. [2] FDP leader Christian Lindner explained in the newspaper Handelsblatt that “(…) on the way to the black zero (…) a deficit for relief and investments is unavoidable (…).[3]

The economic debate

A central argument for reducing the tax burden of companies is international tax competition. It is often argued that Germany is a “high-tax country” and that Germany must be made more attractive for investment as a business location by lowering the tax burden. According to the FDP, tax relief for companies and private households would release additional investment and consumer spending, so that the tax revenues thus generated would more than compensate for the lost government revenue. A resolution of the FDP parliamentary group states the goal of mobilising additional private investment of 120 billion euros per year by relieving the economy of about 60 billion euros. [4]

Taking the example of corporate income tax, one can see that positive effects on investment activity could indeed be expected: An expert report by the IW Köln, commissioned by the BDI, calculated two of the proposals contained in both the FDP election manifesto and in the “Tax Model of the Future” proposed by the Federation of German Industries (BDI). According to this, these measures (the reduction of the corporate tax rate by five percentage points and the complete abolition of the solidarity surcharge) would mobilise an additional investment volume of about 6.7 billion euros and would at least partly pay for themselves within the next decade. [5]

According to a new study by the ifo Institute, the greatest growth effects would be achieved through accelerated depreciation, as this would provide tax relief for both corporations and business partnerships. Using a Computable General Equilibrium (CGE) model, the authors simulate the macroeconomic effects of tax cuts, including reducing the corporate income tax by five percentage points and shortening the tax depreciation period from ten to four years. These two measures would indeed lead to the largest revenue losses in the short term. Immediately after implementation, the tax cut would result in a revenue loss of almost 30 billion euros in tax revenues. However, this would be offset by increases in investment, consumption and employment, so that real GDP would rise by about 3 percentage points in the long run (i.e. more than three years later).

Other economists have raised doubts about the figures cited by the FDP. Philipp Heimberger, for example, suggested: “Anyone who claims high growth effects from falling corporate taxes is raising exaggerated hopes.” [6] This is because, according to Heimberger, empirical studies examining the effect of tax cuts on economic growth do not allow any clear conclusions to be drawn. In a new meta-analysis of over 40 studies, he and Sebastian Gechert find empirical evidence for a selection bias, i.e., that studies showing a statistically significant negative correlation between tax rates and economic growth are more likely to be published than those with contrary or unclear results. [7]

 

Further information on this topic can also be found in the following forum posts:

A stocktaking from the Forum New Economy on fiscal policy theories and the role of the state over time – here.

A Forum New Economy Working Paper by Philippa Sigl-Glöckner, Max Krahé, Pola Schneemelcher, Florian Schuster, Viola Hilbert and Henrika Meyer on the academic debate about the German debt brake – here.

A Forum New Economy Working Paper by Rainer Kattel, Mariana Mazzucato, Keno Haverkamp and Josh Ryan-Collins on new directions for Germany’s post-pandemic economic policy. – here.

A survey on German economic policy conducted by the market research institute Forsa on behalf of the Forum New Economy in 2019 – here.

 

[1] See the decision by the FDP party executive committee reached on 2 June 2020, pp. 2-3.

[2] See the guest article by Betttina Stark-Watzinger (FDP) and Christian Dürr (FDP) in the newspaper FAZ on 22 January 2021.

[3] Christian Lindner in an interview with Jan Hildebrand and Till Hoppe in Handelsblatt on 11 May 2021.

[4] See the decision by the FDP party executive committee reached on 8 May 2021, p. 1.

[5] See Hentze and Golev 2021, p. 16.

[6] Philipp Heimberger in a guest article in Handelsblatt on 3 August 2021.

[7] See Gechert and Heimberger 2021, p. 22.

References

  • Gechert, Sebastian / Heimberger, Philipp, 2021, Do corporate tax cuts boost economic growth? (No. 201). The Vienna Institute for International Economic Studies, wiiw.)
  • Hentze, Tobias / Kolev, Galina, 2021, Wirtschaftliche Effekte des BDI-Steuermodells der Zu-kunft, Gutachten im Auftrag des Bundesverbands der Deutschen Industrie e. V. (BDI), Köln.
  • FDP-Wahlprogramm: "Nie gar es mehr zu tun. Wahlprogramm der Freien Demokraten", Be-schluss des 72. Ord. Bundesparteitags der Freien Demokraten vom 14.–16. Mai 2021.
  • FDP-Fraktionsvorstand: "Neustart Deutschland: entlasten, investieren, entfesseln" Beschluss vom 02.06.2020.
  • FDP-Fraktionsvorstand: "Der Investitionspakt für Deutschland: Digitalisierung und Dekarboni-sierung – entlasten, um zu investieren" Beschluss vom 08.05.2021.
  • Dorn, Florian / Fuest Clemens / Neumeier, Florian / Stimmelmayr, Michael, 2021, Wie beeinflussen Steuerentlastungen die wirtschaftliche Entwicklung und das Steueraufkommen? Eine quantitative Analyse mit einem CGE-Modell, ifo Schnelldienst, 2021, 74, Nr. 10.

We use cookies to provide you with the best possible service. When you continue browsing the site, you consent to the use of cookies. More info.