9: Free markets
Germany's capital-market reforms
The problem: a sclerotic capital market
The German economy is over-regulated and over-taxed. Rising unemployment, soaring public expenditure and entry into the single European currency forced a left-of-centre government to address several long-standing barriers to wealth creation. Germany is dominated by a complex web of cross-shareholdings among the country's largest banks, insurers and industrial groups. Some of the banks' equity stakes were accumulated in the past when companies were unable to service debt interest: today, these cross-holdings are estimated to total € 270 billion.
Tax laws, particularly high capital gains taxes, have effectively discouraged companies and individuals from selling their shares and reinvesting their capital. As a result, the market in corporate control was shackled and stock markets were illiquid. Shareholders have not been encouraged to replace poorly performing managements, and many companies have been sidetracked into operating non-core businesses.
The idea: unlock trapped wealth
It is essential to tackle an anachronistic tax system like this, in order to unlock hidden wealth. In Germany, the left-of-centre coalition government (composed of the Social Democratic and Green parties) introduced a major tax reform plan in 1999 aimed at restructuring the German economy. The goal was to free up immobile capital so that markets can restructure the German economy.
Example: the Schröder reforms
The Federal government of Gerhard Schröder tackled a range of fiscal disincentives that maintained the web of corporate cross-shareholdings. For decades, companies that sold their stakes in other companies were obliged to pay an average capital gains taxes of 50 per cent. Unsurprisingly, few shares changed hands. A package of tax reforms was introduced to promote enterprise and wealth creation. It includes:
Results: the market moves
- Capital gains tax on the sale of shares held in companies for more than one year to be removed from 2002 onwards. For individual investors this will apply so long as the personal stake is not higher than 1 per cent of the entire company. If individuals sell their shareholding within a year of purchase the taxman will levy income tax on half of any gain.
- Personal income taxes are being progressively cut between 1999 and 2005, as shown in the table.
- Corporate tax rates, which previously stood at 40 per cent on retained earnings and 30 per cent on distributed earnings, to be reduced to a unified rate of 25 per cent as from the fiscal year 2001.
The reform of the German tax system is aimed at removing unjustified distortions. The abolition of capital gains tax for stakes in other companies will force companies to reassess their portfolio of investments. Non-core holdings can now be sold without any tax liabilities and the money raised reinvested in businesses that offer a higher return. The conglomerate nature of many German companies is likely to disappear. Many smaller companies will be able to buy underperforming assets and operate them more efficiently.
Some 40 per cent of the publicly quoted equity market is currently held by other corporates. A further 25 per cent is held by financial services companies. According to Commerzbank, given that Germany's equity market capitalization amounts to € 1200 billion, perhaps as much as € 600 billion of non-core assets will change hands as a result of the Federal government's tax reforms. Most of these transactions will probably be made up of small deals. Private equity funds are expected to do very well out of this expected explosion in corporate finance activity.
Companies that have much to gain from the wave of tax reforms have already announced plans for the future:
Assessment: future gains, but still much to do
- In the financial services sector, Allianz, the giant insurer, and Munich Re, the reinsurance group, will reduce their holdings in each other from 25 to 20 per cent by 2003. Allianz reckons its portfolio of industrial holdings amounts to € 40 billion. It plans to exploit the tax reforms to buy and sell holdings more quickly and to diversify its investments worldwide in order to reduce risk.
- Deutsche Bank, which owns stakes of between 8 per cent and 12 per cent in a wide range of major quoted companies such as Daimler-Chrysler and the Continental tyre company, plans to dispose of these holdings in a phased programme. It has already reduced its stake in Allianz from 7 to 4.1 per cent. Deutsche's chairman, Rolf Breuer, said this was proof of "Deutsche Bank's commitment to realize maximum shareholder value by reducing its historical industrial shareholdings."
In terms of its macro-economic impact, the German tax reform package should lead to more jobs, a higher growth rate and a far more dynamic economy. The freeing up of capital markets will stimulate Germany's stock markets, which are much smaller than those in comparable countries.
The tax reforms are already beginning to attract foreign capital. This has two main effects: first, inward investors oblige German companies to restructure their own operations to improve efficiency. Secondly, foreign capital increases the size of the economy through demand for labour and investment products.
On the debit side, high public expenditure, expensive social security programmes and inflexible labour markets continue to arrest economic growth. The tax take on dividends has increased because the government has lowered the threshold to about half its former level
Corporate control in Germany continues to be operated through supervisory boards, comprising managers and employee representatives, and recently this 'co-determination' system has been strengthened. However, investors fear this will further reduce the flexibility and further increase the cost base of German companies, and as a result, capital has been leaking away to the United States and other markets. Until the same liberalization approach is translated from the capital market into the labour market, Germany will continue to face these problems, particularly in the light of the expected further competition from the members of an enlarged European Union.
For further information:
- The German Finance Ministry is in Hamburg, telephone +49 40 605 66040;
- Find Commerzbank at www.commerzbank.com
- Commerzbank (March 2001)The German Tax Reform: Change tax and you change everything: Commerzbank.
- Goldman Sachs Breakthrough in German Tax Reform and Germany Takes the Lead in Tax Reform: Goldman Sachs European Economic Research Group.
Copyright 2002: Adam Smith Institute
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