An Analysis of the German Tax System

At a time when the gap between the wealthy and the less privileged continues to widen, the discussion about the fair distribution of tax burdens is gaining momentum. Germany is the frontrunner in this regard with regard to the taxation of earned income, as the OECD regularly emphasizes in its international comparisons. At the same time, capital gains and speculative profits in Germany are heavily privileged in terms of taxation or are not taxed at all. This is particularly evident in the taxation of wealth, where Germany tends to appear as a low-tax country.

The political debate on how to combat this inequality is characterized by differing views. The CDU/CSU and FDP parties are focusing primarily on education policy and economic growth to provide tax relief for companies and wealthy private investors. On the other hand, the SPD, the Greens and the Left call for higher top income tax rates and the introduction of a wealth tax. But it is precisely the debate on the wealth tax that is often rejected by economic liberals as anti-growth and inefficient. This debate reflects the apparent trade-off between distributive justice and efficiency of the tax system - the so-called equity-efficiency trade-off.

However, this debate often overlooks tax reform options that can combine efficiency and distributive justice. A particularly glaring example of this is the numerous privileges in real estate taxation in Germany, as highlighted in a guest article by Stefan Bach and Sebastian Eichfelder. These privileges almost exclusively benefit the wealthy and at the same time lead to distortions in the real estate market.

In contrast to many other countries, speculative gains from real estate in Germany are only taxed if the property is sold after less than ten years - the so-called speculation period. In the case of owner-occupied real estate, this period is even reduced to three years. This has a particularly worrying impact on rented property, which is held almost exclusively by the richest ten percent of the population.

While investors can claim their acquisition and maintenance costs against tax, later capital gains often remain tax-free. This, in combination with low interest rates on borrowed capital and increases in the value of real estate, leads to high and largely tax-free returns. Taking into account various factors, such as ancillary purchase costs, leverage, capital appreciation and tax rates, the after-tax return on equity employed is only slightly lower than the pre-tax return.

This phenomenon is further reinforced by the high debt ratio and the leverage effect. The effective tax burden on the return is often only about eight percent, mainly due to depreciation and amortization and the tax-free capital gain. For a given ratio of purchase price to net cold rent, the effective tax burden may even be negative because tax depreciation exceeds rental income. As a result, investments in real estate can generate tax losses, while subsequent increases in value remain tax-free.

For the particularly wealthy investors with extensive real estate portfolios, there are even more tax advantages. When real estate is contributed to a limited liability company, the ongoing tax burden on rental income is significantly reduced. In contrast to income tax, where the top tax rate is 45 percent, pure real estate companies pay only 15.8 percent corporate income tax and soli. If the corporate tax rate is further reduced to 10 percent and the soli is abolished, as demanded by the CDU/CSU and FDP, the tax burden is even reduced to just 10 percent.

The situation becomes even more attractive if the Objekt-GmbH is held by a holding company. In this case, only 1.5 percent tax is payable on the capital gain when the Objekt-GmbH is sold, irrespective of the holding period. This "share deal" has the additional advantage that if less than 90 percent of the shares are sold, the entire real estate transfer tax can also be saved.

In addition, real estate tax and inheritance tax in Germany are low compared to other countries. This favors private real estate companies in particular, which can be transferred tax-free as long as the heirs continue to manage the properties. In contrast, people who inherit small houses or property from distant relatives must pay 30 percent inheritance tax on the asset value above 20,000 euros.

In summary: The German tax system favors investments in real estate in a massive way. Wealthy investors are therefore increasingly focusing on real estate ownership, which further exacerbates the inequality in wealth distribution and disadvantages those who live off their labor and own fewer assets. This also has an impact on the liquidity of the real estate market, as properties are often held for speculative reasons and not put on the market. In view of the economic challenges facing Germany in areas such as digitalization and decarbonization, the preferential tax treatment of investments in existing real estate appears highly questionable. Eliminating these tax privileges could generate additional revenue of up to 27 billion euros annually, which could be used to reduce taxes and social security contributions for the middle class or to finance investments in the future. This could improve the fairness and efficiency of the German tax system in equal measure.