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Abolishing the final withholding tax leads to tax revenue losses and barely burdens high-income groups

Press Release of November 8, 2017

Small revenue and distribution effects – Overall, slight tax revenue losses due to a period of low interest rates – Raising the final withholding tax rate to over 25 percent would result in moderate additional revenue

Abolishing the final flat-rate 25 percent withholding tax on unearned income makes sense neither from a fiscal nor a distribution point of view as long as interest rates are so low. If capital income were to be reintegrated into the income tax rate, slight tax revenue losses of 73 million euros would be expected, when taxing 60 percent of dividends and capital gains (partial-income rule) and fully deducting income-related expenses. This is the conclusion of a recent study by the German Institute for Economic Research (DIW Berlin). “Abolishing the withholding tax doesn’t do much in terms of fairness if you understand ‘fair’ to mean higher taxes on high capital income,” says DIW tax expert Stefan Bach. High-income groups would barely be burdened by the abolishment of the withholding tax while medium and low-income groups would experience marginal reductions in dividends. In addition, the amount of administrative burdens in the taxation procedure would increase. By contrast, increasing the withholding tax would lead to moderate additional tax revenues and have a progressive impact, but could worsen investment conditions in Germany.

Since the introduction of the withholding tax in 2009, capital income – interest, dividends, and capital gains – has only been taxed at a final flat rate of 25 percent to prevent the flight of capital to foreign countries. Since this key argument in favor of the withholding tax has become increasingly obsolete in times of international information exchange between finance authorities, more and more voices have at last begun calling for its abolishment. DIW researchers Stefan Bach and Hermann Buslei calculated what this would mean for tax revenue as well as taxpayers according to income bracket in various scenarios.

Only high-income groups with interest income would be more heavily burdened

If the withholding tax is abolished, only high-income taxpayers with interest income would be more heavily burdened. This is because a return to personal taxation solely on interest income comes with an income tax rate that is clearly higher than 25 percent. However, interest income plays a relatively minor role in very high income groups. In contrast, a majority of taxpayers would experience a reduction in dividends and capital gains while taxpayers with very high incomes would only be minimally burdened. For in the case of these income groups, a return to personal taxation would subject them to the “partial-income rule,” which only taxes 60 percent of their income. This is intended to offset the burden of business taxes. This process, together with the possibility to deduct expenses, leads to taxpayers in the highest income percentiles only being moderately burdened.

Overall, this reform would lead to lower revenues with a moderate increase in incomes only occurring when interest rates rise again. This would especially affect middle-income and high-income savers whose capital income primarily consists of interest.

Increasing the withholding tax rate to 28, 30, or 32 percent instead of returning to personal taxation would result in additional revenue of 0.9, 1.5, or two billion euros a year. This would only burden the taxpayers in the highest income decile. On the other hand, investment incentives could be reduced in Germany if dividends and capital gains, including the business tax burden, would burden over 50 percent. This would also be the case with a possible increase in the taxable percentage of the partial-income rule to over 60 percent.

Topics: Taxes

Stefan Bach

Research Associate in the Public Economics Department