Transatlantic Tensions: What the German Election Could Mean for International Tax & Trade Policy

After the collapse of the German government coalition in November 2024, a new federal election will take place on 23 February. Unlike German elections of the recent past, however, this election will take place in the middle of a fragmenting world.

Russia’s invasion of Ukraine continues to put pressure on Europe’s eastern border while newly elected President Trump is once again threatening Europe with a trade war from the West. Meanwhile, France, Germany’s most important European ally, is teetering on a political crisis of its own, bringing the ability of the EU to adapt decisively into question. This is not to mention that the German economy faces major challenges such as a demographic shift in the labor force, energy insecurity, geopolitical pressures on its export-driven model, and weakening growth forecasts.

Consequently, the outcome of the German election will have major implications far beyond its borders, especially in matters of taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. and trade policy. This makes it important to identify key policy decisions, such as the future of Pillar Two, that the next German government will need to make in the broader European and transatlantic context.

Germany’s Electoral Tax Debate Remains Domestic

In a campaign where immigration policy is a central theme, tax policy is not far behind. Parties across the political spectrum have offered a litany of tax policy reform ideas, though sometimes vague, with the promise of boosting economic growth. Predictably, the ideas range from redistributing income to increasing private sector investment to adjusting the ever-discussed debt brake. Without outlining every detail, suffice it to say that parties understand how consequential tax policies can be for voters’ standard of living.

Beyond Germany, each party has outlined certain European and international tax policy ideas in their manifestos, like broadening the EU’s Emission’s Trading System, implementing an EU digital levy if Pillar One fails, or supporting a globally coordinated minimum tax on billionaires. However, candidates have rarely discussed the nuances of how tax (and by extension trade) policies within Europe, or external retaliation to them, could impact these same German citizens. For example, how to manage the impact of potential international disputes over Pillar Two or the Carbon Border Adjustment Mechanism (CBAM) is remarkably absent from party manifestos and campaign speeches. Depending on what forms potential retaliation comes in, the negative economic consequences for German voters of these disputes could far exceed most of the domestic tax reforms regularly being debated.

As the third-largest economy in the world, with an influential voice within EU policymaking, and the United States among its most important trading partners, Germany’s next government will play a particularly important role in deciding the direction of European tax, trade, and transatlantic policy.

Fit for Fragmentation?

At the EU level, policymakers will need to decide if the current tax and trade policies that are designed to establish European standards while simultaneously changing policies of third countries will cause more harm than good. The undertaxed profits rule (UTPR), under the EU’s Directive implementing the OECD’s Pillar Two model rules, and CBAM are examples of EU penalties on foreign firms that could invite retaliatory measures, rather than EU-inspired changes to those countries’ domestic policies. In essence, the continued effectiveness of the so-called “Brussels effect” is in doubt.

The EU’s willingness to enforce the UTPR and CBAM (or not) is no longer a theoretical exercise. On his first day in office, President Trump released multiple executive orders aimed at “discriminatory” international tax (read UTPR and digital services taxes) and trade practices, and once again threatened the EU with tariffs. The orders give US federal agencies until mid-March and the beginning of April, respectively, to provide the president with retaliation options that could be used against Germany or the EU. How the EU would respond to a tax and trade war is still uncertain.

Related to Pillar Two, an international agreement at the Organisation for Co-operation and Economic Development (OECD) on Pillar One looks unlikely. EU leaders have previously threatened to push ahead with digital services taxes (or reattempt an EU-level digital levy) if Pillar One negotiations fail. This would likely add fuel to the fire of an EU-US tax and trade war.

Prominent German political figures have made vague statements about working with the US during the election campaign but have yet to release nuanced plans. These plans could be made more complicated given that responsibility for tax and trade policy in the EU is bifurcated with certain decisions coming from Brussels and others coming directly from national capitals like Berlin. This is not to mention those decisions made at the international level by the OECD or United Nations. Given the large economic impact a dispute with the US could have on German citizens, time to finalize the German government’s response plans is running short.

Even beyond a possible transatlantic dispute with the US, other major economies such as India and China have yet to implement Pillar Two legislation. At best, the EU will avoid retaliatory measures by negotiating safe harbors or similar measures, at the expense of reducing the amount of revenue European governments receive. However, there is a plausible scenario where the EU enforces the UTPR and faces retaliatory measures from its major trading partners. At the same time, European firms could become relatively less competitive due to costly Pillar Two compliance costs and European governments could receive less revenue than expected. At that point, one would have to wonder what positive outcome Pillar Two is accomplishing.

The next German government will be in a position to either continue supporting the Pillar Two project, despite possible retaliation, or call for an overhaul of the system. German leadership on the question of a unified EU position will be paramount.

A Focus on Competitiveness

Beyond external retaliatory risks, the next German government’s position on the future of Pillar Two will be highly impactful within the EU’s domestic competitiveness agenda. The European Commission recently launched a “Competitiveness Compass” strategy outlining steps to make the EU more economically competitive vis-à-vis the US and China. A key feature of the strategy is simplifying regulations and removing inefficient and overlapping tax policies. In EU jargon, this is called “decluttering.”

Pillar Two, in addition to the EU’s Anti-Tax Avoidance Directive (ATAD) and domestic controlled foreign corporation (CFC) rules, is the main policy in question. Germany has already taken steps to shift its CFC rules in light of Pillar Two. However, if the next German government decides Pillar Two is not accomplishing the tax fairness goals originally envisioned, and is rather making European firms less competitive, they could push for Pillar Two to be a part of the decluttering project. This would be a particularly powerful position given that Germany was a strong supporter of the Pillar Two project at its inception.

Germany’s Voice in the EU

The next German government will have powerful contacts in both the European Commission (President Ursula von der Leyen) and European Parliament (Manfred Weber is the leader of the largest group), in addition to Germany’s impactful voice in the Council of the EU. While EU policymakers must consider the economic impacts of EU policies on the whole EU, it certainly doesn’t hurt to have compatriots in key positions.

Ultimately, there will be many consequential tax and trade policy decisions made at the EU level over the next two years. In particular, Pillar Two, CBAM, digital services taxes, and tit-for-tat retaliatory tariffs could all significantly impact German citizens. The next German government should be prepared to help make those tough choices.

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