96 1.3 The influence of tax competition on tax policy One main advantage of our data-set is that we can study tax policy outcomes directly and do not have to rely on nominal tax rates or revenue developments. Do we see an effect of increased capital mobility and tax competition especially on business taxes after 1986? -0,5% -0,4% -0,3% -0,2% -0,1% 0,0% 0,1% 0,2% 0,3% 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 1 3 INCR/GDP RED/GDP BUSINESS TAX REFORMS, 1964-2004 CORPORATE PROFIT TAX -0,2% -0,1% 0,0% 0,1% 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 1 3 INCR/GDP RED/GDP LOCAL TRADE TAX Increase of tax exemption level Abolishment payroll tax Reduction of included long-term interest Abolishment of trade capital tax Reduction of tax rates for small businesses Tax rate cut to 25% Tax rate cut to 45% Tax rate cut to 50% Reduction of tax exemptions in banking Tax rate cut to 40% Fi sc al e ffe ct s ta x re fo rm s/ G D P Fi sc al e ffe ct s ta x re fo rm s/ G D P Temporary rate increase to 26.5% Own calculations based on: Federal Ministry of Finance (2004)/Tax laws.Reforms by date of implementation. Figure 45: Tax competition and business tax reforms Figure 45 shows the fiscal effects of reforms in the most important business taxes: the corporate profit and the local trade tax. We see that reform activity was generally not so frequent in corporate profit taxes. While there were major tax reductions until 1982, especially the rate cuts from 1991 and 1994 led to substantial reductions of the tax burden. The most important corporate tax reforms (with respect to fiscal effects) were the strong rate cuts in 1999 and 2001. The increased importance of tax reductions from the 1990s on can be seen as an indicator for an important influence of tax competition on tax rates. If we compare the periods before and after 1986 (when the US cut corporate tax rates strongly), we find that the average annual fiscal effects of tax reductions in corporate taxation from 1987 to 2004 were 11.6 times higher than the average annual fiscal effects of tax reductions from 1965 to 1986. With respect to corporate taxation, the 97 extraordinary role of the tax rate cut to 25% in 2001, which was promoted by the government as an answer to international tax competition, can be seen as an indicator for an important role of tax competition as well. On the other hand, reforms in the local trade tax were stronger in the 1970s than in the 1980s and the 1990s. Here average annual fiscal effects of tax reductions were 1.8 times higher in the period from 1965 to 1986(especially driven by the abolishment of the payroll tax) compared to the period from 1987 to 2004.175 Therefore, the reform pattern in the local trade tax does not support the hypothesis of a “race to the bottom”. What are the implications for the analysis to follow? First, we conclude from our findings that we need to integrate tax competition as explanatory variable for the corporate profit but not for the local trade tax. If we take into account that the fiscal effects of corporate tax reforms from 1964 to 2004 account only for less than 4% of the total fiscal effects of all tax reforms covered in our data-set, we see that international tax competition had only a very limited influence on our data-set as a whole. Therefore, we are able to largely abstract from tax competition in our general analyses of tax reforms but control for a possible influence on a case by case basis. 2 Normative approaches While we are generally focusing on polit-economic analyses, we do not completely exclude main normative approaches which all largely abstract from political and institutional variables in tax policy. It is especially important for us to analyze, whether normative approaches can contribute to our understanding of tax reforms and are thereby limiting the importance of positive theories.176 We start with the “financing function” of taxation which argues that tax policy is driven by expenditure decisions and the financial needs of the state. The second approach is based on macroeconomic considerations: Are tax reforms scheduled to smoothen the business cycle? Then we discuss the linkage in between inflation and tax policy. Do we see a reaction of tax policy to high inflation and the resulting “cold progression” in progressive taxes? Finally, we shortly review the approach of tax smoothing (see Table 5 for an overview of normative hypotheses). Despite its importance in normative analysis, we do not integrate the theory of optimal taxation as it has only very indirect implications for the variables covered in our data-set.177 175 Please note that we have integrated here only changes on the federal level while changes of the municipal multipliers, which have shown a general upward trend, are not covered. 176 For an overview of discussed approaches see Table 4 on p.90. 177 For a textbook-treatment see Myles (1995). See also Ramsey (1927), Mirrlees (1971), Mirrlees (1976), Auerbach/Hines (2002) and Slemrod (2004).