Considerations on the requested abolition of the flat-rate withholding tax

On 4 November 2016, the state of Brandenburg launched a legislative initiative in the Bundesrat to abolish the flat-rate withholding tax (see BR-Drs. 643/16). Following the introduction of the international automatic exchange of tax data, capital income should once again be subject to the personal income tax rate. This completely undermines the justification given at the time by the then Federal Minister of Finance Steinbrück ("better 25% of X than nothing") for the introduction of the flat-rate withholding tax. The flat-rate withholding tax introduced in 2009 is now an unjustified privilege for higher earners.

The initiative also appears to have met with approval in German government circles. For example, the current Federal Minister of Finance, Schäuble, announced over a year ago that he wanted to "consider in the next legislative period whether we should reconsider the Steinbrück tax reform for capital gains tax, which was based on the imperfection of the recording of capital income" (SZ of 10 November 2015).

The recently adopted reform of investment taxation, which will lead to a complete system change in the taxation of investment funds from 2018, also points to an impending tightening of taxation in some areas. On the one hand, the legislator has already abolished the protection of existing fund units that were acquired before the introduction of the flat-rate withholding tax. These old fund units will be subject to tax from 2018. On the other hand, the combination of new definitive taxation at fund level and additional taxation at investor level will in some cases result in an overall tax burden in future that is higher than the current level of flat-rate withholding tax (cf. Elser/Thiede, NWB Erben und Vermögen, issue 9/2016, p. 299).

So far, the discussion has ignored the fact that the long-prepared introduction of the flat-rate withholding tax in 2009 was by no means justified solely by the above-mentioned fight against tax evasion, but that there were many other arguments in favour of flat-rate taxation with an income tax rate of 25%. It was also propagated by the legislator as a modern form of taxation for private capital income. It therefore seems time to recall these points:

• • Equal treatment with other types of incomeIt is often forgotten that the introduction of the flat-rate withholding tax at the time was not only associated with a reduction in the income tax rate for capital gains. In return, investors have to live with significant tax disadvantages. For example, income-related expenses are not deductible and losses cannot be offset against other types of income. The flat-rate withholding tax is an income tax without tax-reducing cost deductions and without horizontal loss compensation with other types of income. Anyone who wants to abolish the flat-rate withholding tax must reintroduce the old offsetting rules for reasons of equal treatment. Capital gains could then also be offset against losses from other types of income, such as rental income. In some cases, this would reduce the tax burden more than at present.
  • Compensation for the abolition of previously tax-free capital gains on private assetsWith the introduction of the flat-rate withholding tax, a significant tax increase was decided for capital investors at the time: Previously, capital gains on private assets were tax-free outside a one-year speculation period. This was abolished from 2009. The reduced capital gains tax rate served to compensate for this considerable, tax-increasing broadening of the assessment base.
  • Compensation for the prior tax burden on dividends at the level of the distributing corporation: Profits are subject to corporation tax and trade tax of around 30% at the level of the corporation. A renewed full taxation of dividends at shareholder level for distributions would lead to excessive taxation of over 60% and thus to a significant disadvantage for the equity financing of corporations. For this reason, before the introduction of the flat-rate withholding tax, only half of dividends were taxed (so-called half-income method). This was abolished with the introduction of the flat-rate withholding tax, as the reduced tax rate of 25% was applied. If the flat-rate withholding tax were to be abolished, privileged dividend taxation would also have to be reintroduced. Otherwise, debt financing of corporations would be favoured, as interest is tax-deductible at company level.
  • Bsimplification of taxation: The flat-rate withholding tax significantly simplified the taxation procedure for tax offices and taxpayers. Until then, interest, dividends and private capital gains were taxed differently. In addition, in most cases the tax is levied conclusively by the banks. The majority of taxpayers do not have to declare capital gains in their tax return. If the flat-rate withholding tax is abolished, all investment income would have to be calculated again, declared in the tax return and checked by the tax authorities. This would result in a considerable increase in declaration and administrative work.
  • Mitigation of inflation-related fictitious income taxationIt is often argued that other investment income, such as rental income, is also subject to taxation without mitigation. However, this fails to recognise that, unlike tangible assets, financial assets are exposed to the value-destroying effects of inflation. In the amount of inflation, nominal interest represents a fictitious income that merely compensates for the loss in value of financial assets. Taxation of this nominal interest is tantamount to taxation of assets. The lower flat-rate withholding tax rate serves to mitigate this fictitious taxation of income.
  • Steering policy reasons: Finally, the introduction of the flat-rate withholding tax was also justified on the grounds that tax incentives are urgently needed to build up a private pension and also to increase the equity ratio of German households, which is very low by international standards. These arguments have lost none of their topicality.

It can be assumed that the abolition of the flat-rate withholding tax will be discussed by various parties after the next general election. It is to be hoped that such a plan will be carefully scrutinised and that inappropriate conclusions will not be drawn prematurely on the basis of partial arguments. The flat-rate withholding tax has proved its worth in practice. Abolishing it would cause new upheavals and significantly increase the complexity and tax burden for investors and the tax authorities.

Dr Thomas Elser is a tax consultant at TAXGATE, a tax law firm specialising in transactions, investments and tax compliance.