Income tax reform Schäuble's Tax Smoke Screen

Wolfgang Schäuble, Germany's finance minister, wants to introduce a new income tax system to prevent tax-bracket creep. The only problem is that it won't help the people it's aimed at.
Wolfgang Schäuble wants to shake up German income tax brackets.

Last week, Germany’s finance minister, Wolfgang Schäuble, threw a sort of political smoke grenade at the tax system. Starting in 2016, he wants to adjust the income tax rate every two years to eliminate what Germans call “cold progression,” also known as tax-bracket creep. It occurs when pay rises only as much as inflation, but pushes taxpayers into higher brackets.

On the one hand, Mr. Schäuble’s plan addresses complaints over the issue from Sigmar Gabriel, the economics minister and head of the left-leaning Social Democrats, the junior party in Germany’s coalition government. It should also scotch the clamor for extra cash by his cabinet colleagues in a time of increasing tax revenues and surpluses.

One should heed the fact that Mr. Schäuble, a member of Chancellor Angela Merkel’s ruling Christian Democratic Union, did not speak about a “tariff on wheels.” That would couple all relevant tax exemptions, special expenses and income thresholds for the tax burden to inflation.

The finance minister, therefore, wants to push the whole inflation rate curve to the “right,” besides the necessary increases of the basic tax-exempt allowance.

This proposal is a virtual smoke bomb for taxpayers because it doesn’t address the real problem in our income tax system.

The current rates were largely laid down by the tax reforms of the Social Democrats and Green Party coalition 10 years ago. In that reform, the lowest income tax rate was lowered in several steps from 25.9 percent to 15 percent. Also, the top income tax rate was reduced from 53 percent to 42 percent.

Mr. Schäuble’s proposal will change virtually nothing about the cosmetic effect of the tax rate.

At the same time, however, the progressive effect of the new rate curve was tightened. The minimum exempted income was increased in cooperation with the gradual lowering of the threshold.

Thus, the threshold for the 42 percent tax rate was lowered in several steps – from €61,376, or $69,917, in 1999 to €52,152 in 2004.

Since then, the basic tax-exempt allowance has risen 10 percent, but the threshold at which the 42 percent rate kicks in rose by only 1 percent. The rate curve was therefore greatly compressed.

The real problem of our income tax rates is therefore not future price increases, but rather the massive progressive tightening for more and more taxpayers, especially low- and middle-income earners.

Also, more and more working households are subject to the 42 percent tax rate. In 2005, it applied to 1.2 million households, and in 2010, 1.5 million. This year, it will be more than 2.3 million households. This figure will rise further,  with increases becoming more pronounced the higher the wage dynamic caused by an aging population grows.

Mr. Schäuble’s proposal is of a purely cosmetic nature and will change virtually nothing about the tax rate. For a low-income earner, a wage hike of 3 percent will lead to an increase in taxes of about 9 percent. For middle-income earners, the tax burden would increase by about 4.5 percent.

The consequence is that low- and middle-income earners would have to bear a continually increasing share of income taxes – despite new tax exemptions for retirement contributions.

From a tactical and fiscal point of view, Mr. Schäuble’s plan might seem successful. But from a public financial point of view, it is not.

The urgently needed flattening and extension of the tax scale – counter-financed with a moderately higher top tax rate starting at €70,000 if needed – will only be put off for longer.

The state of Germany’s public finances is as good as it has been for decades. Federal, state and municipal governments have been in the black since last year. But while tax revenues are still rising, the distribution of the income tax burden increasingly diverges from the original ideal of justice in tax rates.

 

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