Germans Flip Over Tax Reform (In A Good Way)

German business leaders are euphoric over a tax overhaul that lets them redirect investment once tied up in other German companies, and funnel it into high-growth sectors like high-tech. But there is growing concern among German retail investors that the package, introduced by the German government after years of debate may pose more questions than it answers.

The tax scheme, expected to reduce by almost DM60 billion German tax receipts by 2005, includes a provision that removes corporate long-term capital gains taxes. This ends the post-war German tax regime which effectively required German companies to hold stock in one another.

Business leaders hail the long-debated reform, and are almost counting their earnings already from investments in euro-dot.coms and high-tech ventures. But according to an n-tv poll published in the Abendzeitung, 51% of Germans surveyed said they felt that the tax package would hurt, not help them, despite a personal income tax cut for both low and high income earners.

Some labor leaders worry that a mass shift of funds by banks and insurers away from more esoteric or even merely poorly performing holdings and into industry consolidation and mergers and acquisitions could threaten German jobs, and the decades-long peace between German industry and labor unions.

But business leaders insist that freeing up their investment capital will allow them to invest in high growth sectors. “This decision increases strategic development for German corporations,” said Stefan Radloff, Senior Vice President Accounting & Financial Controlling, for Infineon Technologies, “However, we do see further discussion necessary regarding individual points of the decision, particularly within the area of corporate income tax law and tax write-off regulations.”

The funding from capital gains “will allow companies to focus on their core competencies ,” said Peter Klostermeyer, senior analyst at VMR, “German old economy companies, for example, in steel and mining, already have in place an IT business or Internet division, so they’ll probably take money out of cross-investments and use it to build up and possibly spin-off these divisions.” The value-adding investments would garner the attention of investors and increase stock prices.

Cross-holding was introduced after WWII as a means to promote consensus among German corporate management, which had to maintain holdings in diverse industries – such as insurance companies investing in tire manufacturers, construction firms and banks. The velvet hammer of compliance with this system, widely credited with smoothing the course of the German Wirtschaftswunder – economic wonder – was that corporations would be hit with earth-shattering capital gains taxes should they sell their cross-holdings.

All that changed when the compromise, a mainstay of parliamentary debate in Germany since before the Kohl era, was passed.

German Business Ready To Rock
Though the Financial Times has reported that Deutsche Bank Chairman Rolf Breuer plans aggressive divestment of Deutsche Bank’s estimated €23 billion in industrial holdings (including DaimlerChrysler and until last month, insurance group Allianz), Breuer has made clear the bank “…will try to avoid overcrowding the market with potential sellers. We will have to do it smartly.”

Banking analysts also believe that the odds of a fast-paced sell-off are slim. “As far as I can see, this will encourage some divestiture, but on balance I think this issue may be overblown,” said an analyst at Commerzbank. “Banks have really enjoyed the earnings smoothing capacity of these cross holdings, which has allowed them to realize profits that can offset costs such as restructuring – without this, the volatility in the German banking climate over the last few years would have been very significant. And dumping the shares would dilute the price, and banks aren’t dumb.”

Analysts also say that in addition to pure financial motives that would encourage a steady and slow sell off as opposed to a rapid money move, there is also a very real sense of tradition.

“These are legacy positions,” said the Commerzbank source, “and there are some very strongly-held views that these are the family shield, so you won’t see a wholesale sell off within a short space of time, but rather a slow, gradual process.”

But the overhang – the market’s sense of “waiting for the other shoe to drop” on releases of chunks of stock, may in itself provide downward pressure on German stock prices over the long term.

Changing Insurance Landscape
For the insurance industry, at least for insurers with large portfolios, the newly found freedom from cross-holding would seem to be an equal shake. While German companies in other industries will surely divest themselves of some of their insurance holdings, German insurers will be free to consolidate further within Germany as well as to expand across European borders.

“This won’t mean any immediate change in ratings,” said Karin Clemens, Associate Director at Standard & Poors, “but this will speed up the consolidation process within the German insurance market. And it would mean opportunities to broaden. For example, Allianz can’t further expand in Germany, so we would expect them to try to build their positions outside Germany – but we also expect further that it will allow foreign insurers the chance to get in to the German market.”

Labor Unions
Some have expressed concern that shifting capital out of certain sectors could threaten German jobs, and the peaceful relations between industry and labor unions that has been a hallmark of the German post-war success.

“We support the tax reform package in general, and think it is good for Germany and for Europe” said Claus Eilrich, a spokesman for IG Metall, Germany’s largest labor union, “but we have some problems with the corporate capital gains cut. Germans must pay a tax for everything, so we question why large corporations should get what amounts to a present from the government – this even took the insurance and banking industries by surprise.”

Personal Income Tax
The German plan also provides a healthy tax cut for the wealthy, and much smaller cuts for middle and lower income earners. Some believe that this “Supply side” approach creates an unbalanced economic model, but German economists feel confident the mixture is a prudent one.

“That supply-side issue is always a problem,” said Rudiger Parsche, Expert for Financial and Tax Matters at Munich’s IFO Institute for Economic Research, “but I think this package has a good mix, reducing tax rates significantly and increasing the minimum amount of tax free income to DM15,000 by 2005. So taken altogether we suppose that the package will also increase the demand side.”