Return of the Wealth Tax

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Amid rising government spending, and an ongoing increase in inequality between the rich and the less fortunate, one controversial idea is making its comeback into public discourse: The wealth tax.

It is a hotly debated topic. Entrepreneurs and pro-business lobbies argue that it creates undue burden and ‘dry income’ on businesses who should focus on maintaining their market position and legacy. Left-wing political parties and think tanks argue that it is the only fair way to stop rising inequality, especially after an unparalleled rally in risk assets over the last decades. 

In this newsletter, our priority isn’t debating who is right or wrong. Instead, we want to address a question that my co-founder Tamara and I are hearing more frequently these days: How could a wealth tax look like in Germany - and how can I protect myself?

We’ll start with the history of the wealth tax in Germany (hint: It’s actually not a new thought), before looking abroad to other jurisdictions. Finally, we’ll look back to how Germany could re-introduce its wealth tax (or comparable measures) - and of course also address potential countermeasures. Let’s dive in!

90s Throwback: The Wealth Tax in Germany

Many (younger) individuals are not aware that a wealth tax is actually not a new concept in Germany. Until 1996, Germany levied a net wealth tax of 0,5% p.a. on individuals, as well as 0,6% p.a. for corporations. Annual revenues from this tax were meaningful, standing at approx. 4,6BN€ per year.

However, in 1995, the German Constitutional Court argued that the system to be unconstitutional due to unequal approaches to valuation of assets, especially differences between financial and real estate assets. However, the Wealth Tax Act was not repealed, but instead simply put on hold until a new, constitutional framework was found - which however never ended up happening.

Amid the aforementioned circumstances, popular discourse is seeing an increased call to reinstate some sort of wealth tax here in Germany. The German Trade Union Federation (DGB) proposed a progressive wealth tax of 1-2%, starting at 1M€ in net wealth. Think tanks like the DIW instead advocate a levy on large private fortunes as well as corporate shares. Political parties, unsurprisingly, are very split in their views, with left-leaning parties such as the Greens and Die Linke supporting various models of a wealth tax, while the FDP and CDU/CSU clearly oppose it.

Wealth Tax Around the World: A Patchwork of Models

One might think that a wealth tax is simply a Germany-specific relict of our ‘social democrat’ past. But that’s actually not correct, either: Across Europe, there is a number of approaches to wealth tax in place, some in unlikely places.

First, our neighbor France. France used to have a general wealth tax, which was abolished in 2018 and replaced by a real estate-focused wealth tax. France levies a wealth tax of 0,5-1,5% p.a. on real estate wealth worth more than 1.3M€, with deductions for an individual’s primary residence.

Second, moving south to Spain. Perhaps the wealth tax that Germans are most familiar with, given how many affluent individuals own second homes on Mallorca: Spain levies a wealth tax of 0,2% to as high as 3,5% p.a. on all assets, with 700K€ personal exemptions. However, actual enforcement varies substantially: While some regions enforce it fully, the city of Madrid, for example, has suspended the enforcement.

Third, our neighbor to the south, and perhaps surprising to some more ‘Libertarian’ investors: Switzerland. Switzerland levies a wealth tax at the cantonal level ranging between 0,1% to 1,1%, covering assets such as bank accounts, financial assets, real estate, or shares in unlisted companies. While one wouldn’t expect the otherwise tax-friendly regime of Switzerland to levy such as a tax, we found it to be accepted socially and politically given the high degree of transparency and digitization of the Swiss tax system.

Fourth and last, Norway. Norway levies a wealth tax of up to 1,1% p.a. on net assets starting ‘as low’ as 150K€ (NOK 1.76M), and even including the value of an individual’s private residences. While maybe not a jurisdiction that German investors would typically find themselves in, we found it notable as an example of potential impacts of a wealth tax in action: Since implementation of the wealth tax, Norway has seen substantial wealth migration (esp. to Switzerland). One notable story that I personally followed was founder Frederik Haga, who left after Norway had charged a wealth tax on the substantial, yet unrealised paper value of the shares in his company.

How could a (new) German 'wealth tax' look like?

Now that we know how the wealth tax used to look like in Germany, and how other countries do it - how could the reality of a ‘new’ wealth tax in Germany look like?

The ‘simplest’ thought experiment would be to assume a reinstatement of the original wealth tax, i.e. an annual levy of 0,5-1,0% p.a. on the assets of individuals and corporations. Key questions which resulted in the abolishment of the original wealth tax remains, in particular around valuation of illiquid assets, such as real estate and private companies. Furthermore, there is a question of which discounts and/or allowances would apply.

Such a wealth tax, in our view, would be somewhat of a pivot from Germany’s favorable treatment (in our view) of more affluent investors, i.e. those utilizing holding companies (and the subsequent §8b KStG). Investors in illiquid companies would now face annual liquidity stress, especially in the absence of dividends and/or actual realizations. On the other side, active investors without such holding companies and/or income-generating assets might still face the tax, but fare relatively better.

Mitigation of such a tax would likely lead to an increase in relocation of individuals away from Germany (which might trigger exit taxes), and/or a stronger focus on ‘valuation engineering’ - think minority discounts and an increased use of value-reducing debt.

Perhaps a valid question to pose here - do we think that reimposing the wealth tax in its current form is likely? Admittedly, we are not certain. There are valid reasons why the wealth tax was abolished in its original form, and those particular question around asset valuation (which by nature is not only science but also art and Auslegungssache) remain. Tamara and I had to debate asset values with the Finanzamt before: Even for ‘simple’ assets (think a profitable business with one product), valuation discussions can take months. Extrapolating that to all businesses, every year seems quite frankly impossible.

So instead, let’s consider two ways how a wealth tax, in our view, could be implemented ‘through the backdoor’.

First, a substantial increase in the Abgeltungssteuer (i.e. the capital gains tax) from 26,375% to a percentage in-line with income tax (i.e. 40%+).

Taken by itself, such a change would, in our view, be a minor change to many of our clients. Most of them already have holding companies, covering private liquidity requirements through a salary from their holding company and/or shareholder loans over (eventual) distributions. In the worst case, we could also see this having the often-feared effect of negatively affecting the middle class (unless such a tax increase would be limited to high income minimums).

If such an implementation were to happen, we’d see a continued push into structures that offer tax deferrals, including holding companies, fund vehicles, or insurance wrappers. Furthermore, investments might shift towards accumulating investments - maybe even resulting in German public companies favoring buybacks over the often-sought dividend. Lastly, for wealthy individuals directly impacted by such a tax increase (i.e. company shareholders without a holding company ‘in between’), we could foresee a residency shift towards companies with lower effective rates, such as Switzerland, Italy, or UAE.

Second, an abolishment of §8b KStG in its current “unlimited” form, i.e. the preferential tax treatment of investments in corporations (Kapitalgesellschaften) through a holding company (i.e. UG/GmbH/AG) regardless of the size of your stake.

In our experience, many German investors underestimate how favorable §8b KStG really is. You don’t need to have a substantial minority stake (think 10%+) in a million-dollar family business - you gain the full, favorable tax treatment (95% reduction in payable taxes) for as little as one Nvidia share (technically a stake in a corporation) held by your UG (also a corporation). While many other European countries have comparable approaches, they often require minimum ownership stakes in a two-digit percentage range (i.e. 10%+), in-line with the beautifully named EU Parent-Subsidiary Directive (Directive 2011/96/EU).

Hence, if a future government is looking to boost tax revenues, it wouldn’t be unthinkable for them to consider aligning German law with said EU directive by also requiring a minimum 10% ownership in order for an investor to benefit from the 95% reduction in tax.

And in our view, such a change would be very painful to most affluent investors - perhaps even more painful than a wealth tax. Investments in individual shares as well as many privately listed companies would become economically impractical at the holding level given the higher tax rate (~30% at GmbH/AG level) and theoretical double taxation (another 26,375% to distribute to the private level). Essentially, the previously very attractive Holding-GmbH would from one day to the other become much, much less attractive.

Mitigation would also be challenging. For investors that already have their money in a GmbH, distributing to the private level would result in a substantial one-off tax burden - if even possible for illiquid assets. There are also also only few ‘traditional’ investing strategies that would retain appeal, as the only other favored investment would be equity-oriented ETFs and funds (through the Teilfreistellung). We might also see a stronger tendency towards “club deals” or funds with a small circle of investors (i.e. 10%+ ownership per shareholder) in order to retain the 8b benefits. Lastly, one could try to replicate tax-advantaged strategies that are currently used primarily at the private level to generate deductions to offset the high taxable income - but that would likely not be worth the effort, if the same can be done at the private level at a slightly favorable tax rate (26,375% vs. ~30%) to begin with.

Anticipating the Unknown

Yet another thing to note when it comes to the anticipation of changes to the tax law: It is very hard, if not impossible, to imagine how any type of less favorable new tax treatment might look like. 

Even for existing tax laws, new rulings can happen that change the status quo entirely. We can try to anticipate how a wealth tax might look like - but mitigation strategies might then differ substantially based on the exact implementation of this hypothetical new tax law.

So instead, let’s make use of a core tenet of investing, and apply it to our tax structure: diversification.

Take our prior example of an abolishment of §8b KStG. If you as an investor are currently very reliant on your holding GmbH (i.e. all assets held at that level, with little to no assets at private level or elsewhere), perhaps it is worth considering diversifying where your assets are held and taxed. That could be a theoretically ‘unfavorable’ distribution of liquidity to the private level, which might cause a one-time tax hit, but puts assets (and gains/losses) into a tax regime separate from how GmbHs are treated. You could also consider diversifying away from purely financial investments (stocks, bonds, etc.) into operating companies that generate operating income and (often tax-deductible) expenses. You could look into ‘wrappers’ such as an investment fund or an insurance policy. Or you could even consider moving some of your assets abroad into an entirely different tax jurisdiction.

In the end, there is no right or wrong. Perhaps such measures might even be (temporarily) disadvantageous from a tax perspective. But like traditional diversification, you don’t just do it for the short-term but the long-term benefits: If you had a life-changing liquidity event, it’s tempting to focus solely on (tax-advantaged) wealth generation to grow your assets even further. But in practice, we often see clients prioritize wealth preservation and protection - including safety from unfavorable tax-related events - only after the fact. We recommend not to make that mistake: In our opinion, the real question is not if a measure like the wealth tax returns or not - but whether you are prepared if it does.

Closing Remarks

Wealth taxes, without a doubt, are politically attractive in today’s day and age. Symbolically, they suggest fairness and redistribution, and in theory could be a tool to combat rising inequality. Yet in practice, as we have outlined, they are complex, distortion-prone, and can easily trigger a capital flight if not carefully designed (as we saw in Norway). 

Germany could theoretically re-introduce the wealth tax tomorrow if a more left-leaning coalition comes to power (as we are seeing in the UK). Furthermore, many European neighbors show that challenges such as valuation frameworks or exemptions for personal residences and productive assets can be solved. Or as already mentioned above - it’s a real possibility, and as we outlined above, you should be prepared if it happens.

Besides ‘national’ mitigation mechanisms, you might have the same thought as some of your Norwegian peers: Why not just leave Germany behind and move elsewhere where I pay less taxes, or maybe no taxes at all?

While we understand that sometimes taxes can feel disproportionate or even unfair, make sure that you control your money - and to not let your money control you. We know stories of individuals who left Germany for a Mediterranean island nation to save taxes, but now find themselves on said (not so exciting) island six months of the year, while having to make sure that they never spend too much time in Germany or elsewhere.

If you are amongst the lucky few who’ve made life-changing amounts of money, don’t forget to be happy about it. Yes, think about how your ideal tax setup can look like. Diversify across different tax ‘regimes’ (even within Germany) to hedge yourself against a change in tax law. Or maybe even consider leaving Germany if you actually want to live somewhere else. But don’t just do it for the money. 

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