It Certainly Could Be a Bit More!

"Bracket creep" is one of those dry topics that might well be of interest only to tax experts and economists. It refers to the increased tax burden that results when tax rates are not adjusted to reflect inflation or GDP growth. In Germany, this issue is hotly debated as of late. Indeed, bracket creep (or, in German, kalte Progression) has become a catchword for broad tax relief proposals that impact every taxpayer. Yet is the call for lower taxes to compensate for bracket creep justified?

When personal income rises, whether this is the result of inflation or real economic growth, and tax rates remain unchanged, then the tax burden on the individual increases. A growing share of income is redirected to the state. This imbalance creates two problems. First, it makes the public sector expand at the expense of the private sector. While a shift of this kind might represent a deliberate policy measure, it should not take place surreptitiously; it needs to be openly discussed and accompanied by transparent tax increases. Second, bracket creep produces changes in the distribution of the tax burden. Of course, all taxpayers end up with a greater burden, but the increased burden is especially painful for low-income earners for whom every euro matters. Once again, such changes should not be the consequence of automatic and non-transparent tax increases.

What is the current situation in Germany? In several aspects of the income tax, the presence of bracket creep is clearly discernable. For example, since the most recent income tax reduction in 2005, the basic tax exemption threshold (Grundfreibetrag) has risen from 7,664 to 8,130 euros through 2013, or by only around six per cent. During the same period, however, GDP rose by around 23 per cent. In 2014 the basic tax exemption will rise to 8,354 euros, but this will not alter the fact that it still lags far behind overall economic growth.

At the same time, though, we should remember that there has also been relief from certain tax burdens in recent years, such as an increase in the child benefit and the introduction of deductibility for home contracting needs. These measures counteract the expansion of tax revenues resulting from bracket creep. So has the government truly eaten up a greater share of overall economic power? For a number of decades, total tax revenues for the federal, state, and local governments have ranged between 20 and 23 per cent of GDP. In 2005, the government’s share was unusually low, at 20.3 per cent, because of the tax relief measures that had just been enacted. By 2013, this figure had risen to 22.7 per cent, and thus was at the upper end of its usual variation. One sees a similar pattern in the rise of the income tax. Revenues from taxes on wages and the assessed income tax rose between 2005 and 2013 from 5.8 to 7.3 per cent of GDP. Thus, today’s high tax rates are comparable to those during the 2000s. It was at that time that the last major reduction in the income tax was enacted and implemented by 2005. According to current tax projections, if there is no tax relief, tax revenues will continue to rise more rapidly than economic performance for the next few years.

One must also note that government budgets are currently balanced and that political leaders have responded to the surge in tax revenues by relaxing their discipline on expenditures. Discussion about limiting the role of government and reducing subsidies has virtually ceased, even though this is urgently needed. Instead, vast government spending is on the table for questionable projects, such as the reduction of retirement age to 63 years for certain groups.

Given this backdrop, the situation is clear: The time has come for a major income tax reduction to make up for bracket creep. Federal Minister of Finance Wolfgang Schäuble has proposed a reduction in the amount of three billion euros. To this, I would respond: it certainly could be a bit more!