We Need to Create More Work Incentives in the Transfer System

Does the tax and transfer system cause greater social inequality? The German tax and transfer system is continually criticised for being too complex and not transparent enough. In fact, the combination of social security contributions, income tax and transfer payments such as housing and child benefit can even mean that, for some people, an increase in income does not lead to more money in their pocket. This is particularly the case for the marginal burden, which represents the proportion of each extra euro earned that has to be handed back to the government. ZEW family economist Holger Stichnoth is critical of these disincentives in the German tax and transfer system.

A higher gross income doesn’t necessarily mean a higher net income. Which income groups are most affected by a high marginal burden?

Though the German tax system is progressive, meaning that it generally taxes higher incomes at a higher level than lower incomes, in order to conduct a comprehensive assessment of the system as a whole, we have to look at welfare benefits and social security contributions as well. In the case of social security, individuals with an income below the assessment threshold no longer have to make these contributions. Transfers such as long-term unemployment benefit (ALG II), child supplements and housing benefit are paid out based on income, meaning that losing these payments if their income increases represents an unwanted burden for those receiving them. Therefore, it is primarily this lower end of the income distribution that is most affected by high marginal burdens.

What does that mean exactly?

People who receive ALG II benefits will lose 80 cents of every euro earned over the annual exemption limit of 12,000 euros. For these people, as well as people who receive housing benefit or child supplement, a reduction or loss of these benefits typically results in a marginal burden of between 80 and 100 per cent. In extreme cases, one might even see a marginal burden of considerably more than 100 per cent. In such cases, a higher gross income leads to less net income. Particularly hard hit by this phenomenon are single parents and couples with children. The former group, for example, need to earn at least 23,800 euros a years to reach a marginal burden of around 40 per cent, while the latter are able to reach this relatively low level with an annual income of 36,300 euros if only one partner is earning and 40,800 euros if both are.

Is it still worth it for low earners to take on additional work?

In the lower income brackets, workers only see a small portion of the potential extra earnings due to the loss of benefits. At a marginal burden of 80 per cent, an additional hour of work at the minimum wage of 8.84 euros an hour only produces 1.77 euros in additional available income. From a financial perspective, the extra work is hardly worth it. From the worker’s perspective, there is a great temptation to top up their wages through undeclared work, as this means that every euro they earn goes straight into their pocket. Because high earners at the other end of the income spectrum are faced with a much lower marginal burden in comparison, they have greater incentives to work extra hours. As a result, these different marginal burdens lead to greater inequality and distortions.

What can policymakers do to tackle this issue?

There is certainly room for improvement, for example, with regard to harmonizing individual benefits such as ALG II, child supplement and housing benefit. Large jumps and spikes in the marginal burden could be eliminated by implementing a standard transfer withdrawal rate. This could also bring about more transparency in the transfer system. What is more, this would most likely have positive employment effects. It would, however, also be possible to improve individual benefits without implementing such fundamental reforms. For instance, the new federal government is currently planning to remove existing cliff edges in child supplements. This is a welcome initiative.

What can Germany learn from planned tax and transfer reforms in other countries?

In the US and Scandinavia, individual transfer payments have already been merged into a single payment, and in the United Kingdom, the responsibility for welfare benefits is assigned to a single agency. In this regard, studying the experiences gained from these countries could help German policymakers to assess and design different reform measures.