The ‘Middle-Class Bulge’ Is Set to Become Smaller After the German Federal Election

The German government is literally rolling in money. Calculations carried out by the German Federal Ministry of Finance indicate that additional tax revenues are likely to amount to 46 billion euros between 2018 and 2021. This should be enough reason for policy-makers to implement comprehensive tax reforms after the federal election. What can and needs to be taken into consideration when implementing such reforms? And is it realistic to expect tax relief? ZEW family economist Holger Stichnoth provides some answers to questions regarding possible future tax policies in Germany.

Tax cut promises are popular election campaign tactics. But is it really possible to level out the so-called “middle-class bulge” without putting an additional burden on low and medium income earners, while at the same time coping with the resulting tax revenue losses?

With the progressive income tax rate, higher incomes are taxed more heavily than low and medium incomes. It would therefore be untrue to say that the German middle class is subject to a disproportionately high tax burden. It is, however, true that for low and average income earners marginal tax rates rise very rapidly in the German income tax schedule. I am convinced that this so-called “middle-class bulge” is set to become smaller after the election. This comes, however, at the cost of tax losses. The extent to which the middle-class bulge will be reduced depends on whether policy-makers are willing to forego tax revenue, or if they try to compensate for the resulting shortfalls in other policy areas.

Would it be beneficial to raise the top tax rate from a current rate of 42 per cent to 49 per cent?

Raising taxes on high-income earners would indeed be a possible solution to partially compensate for the losses arising from the reduction of the middle-class bulge. What is more, a higher top tax rate would likely have a positive signalling effect, especially in light of the growing gap between rich and poor. The actual redistribution effect would, however, not be very significant, since a reduction of the middle-class bulge does – although the name may suggest otherwise – not only benefit the German middle class but also high and top income earners. This would partially absorb the effect of a higher top tax rate.

Should the existing income tax splitting between married couples be eliminated and replaced by individual taxation?

As a result of income splitting, spouses are taxed at the same marginal tax rate, which means that an additional euro earned by the person with a lower income is taxed according to the same rate as a euro earned by the partner with a higher income. This has contributed to the fact that many women in Germany are working in part-time employment or in so-called mini-jobs. In my opinion, it would therefore be desirable to eliminate, or at least limit, income splitting. As a consequence, however, those couples that have chosen specific forms of employment thanks to the possibilities offered by the current legislation would lose out. The provisions on income splitting should thus not be changed overnight; they should be adapted gradually.

Is there a way of compensating for the bracket creep due to inflation?

One possibility would be to make the income tax rate more flexible in a way that it automatically adjusts itself according to inflation or income development. Personally, I would prefer to leave it to the discretion of legislators to set a time frame for this adjustment since this approach has proved successful in the past. Furthermore, the bracket creep acts as some kind of automatic stabiliser for the business cycle. If incomes experience strong growth during economic upswings, income tax revenues rise disproportionately. On the other hand, declines in tax revenues dampen income decreases.

Would it be beneficial to keep the solidarity surcharge in order to cover unexpected additional costs, such as rescue packages fordefaulting Member States in the Eurozone?

It is most unlikely that a German solidarity surcharge for the Eurozone would gain majority support. You can, of course, always argue against tax cuts – be it with regard to the solidarity surcharge or income taxation – by pointing towards the need for government spending on, for example, schools or infrastructure. This touches on a central policy question: Which tasks should be assigned to government bodies and which of those tasks should be financed through taxation? The question of whether the solidarity surcharge should be levied apart from or integrated into the income tax is thereby of secondary importance.