The Tax Break Man

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What a difference a year makes in German politics. Last summer, the opinion polls for Chancellor Gerhard Schröder's Social Democratic Party were threatening to fall off the page. The party was soundly defeated in five straight state and local elections. The reason? Popular discontent over government plans to slash expenditures and reduce debt. It seemed as if Schröder's time in office might be cut as fast as the budget.

Last week, however, Schröder pulled off a major victory. Confounding his critics, Schröder at the last minute garnered enough votes to push through what many consider to be the most significant overhaul of Germany's tax system since World War II. The plan will slash corporate taxes from 40% to 25%, eliminate capital gains tax on the sale of stock by corporations, and cut the top rate of personal income taxes from the current 51% to 42% in 2005.

"This marks the end of Germany as a high tax location," said Holger Schmiedling, an economist at Merrill Lynch in London. "It means that Germany will be much more attractive as a place for outsiders to invest, and also means that Germans will have less incentive to invest their own funds overseas."

Finance Ministry officials said Schröder brought around doubters in the Bundesrat, the upper house of parliament, by agreeing to two important compromises: dropping the upper income tax limit a further point from 43% to 42%, and granting a one-time tax break for mid-sized companies — the famed Mittelstand — that allows owners to sell them and pay no taxes.

"Germany is once again playing in the first league," said Finance Minister Hans Eichel. Friedrich Merz, leader of the opposition in parliament, complained that the legislation helps bigger companies at the expense of small firms. "The differences in taxing enterprises and entrepreneurs changes the structure of the German economy to the disadvantage of the Mittelstand," he said.

Perhaps the most controversial part of the tax reform abolishes capital gains tax on the sale of shares by corporations. In the past, Germany has been dominated by a few big companies, such as banks and insurance companies, that held cross holdings in other big corporations. The capital gains tax was an effective bar to selling those stakes. "The end of the capital gains tax will help to unblock the restructuring of Germany that has been in the pipeline," said Thomas Mayer, chief economist at Goldman Sachs in Frankfurt. It was unfortunate that the government had to agree to a one-year delay to win passage of the measure, Mayer said, "but a delay is much better than no deal at all."

Schröder might have failed to push through his reforms if the opposition Christian Democrats were not preoccupied with a campaign finance scandal that erupted last year when former Chancellor Helmut Kohl admitted receiving illegal secret contributions. Ironically, Kohl's Christian Democrats had proposed their own tax cuts in the mid-1990s, but were blocked by spd leftists. If there is one sure thing in politics, it's that a tax cut is so popular that every politician wants to claim it as his own.