Latest the Bavarian governor Horst Seehofer demanded for a reduction of the income tax in order to fight the bracket creep in Germany. In January 2017 he wants tax breaks of a single-digits billion euro. Finance Minister Wolfgang Schäuble replied on this claims last Wednesday presenting calculations of his ministry. The outcomes show that only 5 euro per taxpayer and month will be on the account of the cold progression in 2015. A public dispute about the so-called bracket creep arouses frequently in the run-up to elections. It is an instrument often used to justify election pledges in form of income tax cuttings. So is the actual bracket creep no problem as Schäuble indicates and the recurrent discussion on that topic just cheap talk to butter up the voters?
Before answering that question it needs to be clarified what the cold progression or bracket creep is.
In Germany as in many other countries taxes are levied by the ablility-to-pay principle. That simply means: who earns more has to pay more taxes. This principle is implemented by a progressive tax rate where the effective average tax rate increases with higher incomes. Bracket creep comes into being when the wage increases in order to compensate inflation. Let us assume we have an inflation of 3% per year and an increase in gross wage of 3% as well. Nominal wages increase whereas real wages stay constant. What happens to the tax then? Although the purchasing power of the individual hasn’t change he has to pay more taxes, which means his real net wage is lower than before if the tax threshold isn’t adjusted. Therefore cold progression is also known as “secret tax increase”.
What about the situation in Germany?
The argument of Wolfgang Schäuble is not really convincing. Admittedly the amount of 5 Euro per month and taxpayer doesn’t sound very impressive, but in a long-run consideration it sums up. In the year 2016 the ministry of finance estimates the costs for the taxpayer at 72.34 euro per year, thus about 6 euro per month. Altogether this would be about 130 Euro for the years 2015 and 2016.
If the adjustment of the marginal income tax rate remains undone, the incentives to work are weaker and the growth of potential out is below its best. This is supported by Süssmuth and Heer that found that a long duration between two adjustments in tax rates fosters a decline of employment, outputs and savings. That is in line with a recent request of the ECB-director Coeuré and his predecessor Asmussen that ask the German government to cut taxes in order to support investments and reduce tax burden of employees, which could strengthen the domestic economic trend.
Because of that reasons adjustment in the income tax rate is necessary and the government should not spare at this end.
Clara Mareike Pott