Cold progression correction is necessary

With his proposal, the Federal Minister of Finance corresponds to the meaning of the Bundestag resolution of March 29, 2012, which calls for a tax progression report every two years. Accordingly, since 2016, his predecessors Wolfgang Schäuble and Olaf Scholz have shifted the key values ​​of the income tax rate with the price increase rate. For that reason alone, the criticism now being made is incomprehensible.

Christian Lindner is following Parliament’s mandate, one could at most ask why the tax on the wealthy should be exempted this time in the sense of anticipatory adaptation of distribution policy to the media discourse. Otherwise, the shift in tariffs changes little in the real distribution effects of income tax – the share of the top ten percent in tax revenue even increases slightly.

The adjustment is intended to avoid an inflation-driven automatic and thus both arbitrary and uncontrollable tax increase for taxpayers. The income tax rate with its nominal parameters is decided for a given real income and its distribution over a year. If nominal incomes now rise in line with the rate of inflation – i.e. incomes remain constant in real terms – without correction of the cold progression, the average tax rates would rise automatically because the key values ​​of the linear-progressive tariff are rigid. This means that the tax burden rises faster than income and thus the real tax burden rises without this tax increase being legitimized by the Bundestag.

Due to the massive inflationary imports, the inflation rate is likely to rise faster than nominal income this year, and real income will fall. The cold progression increases the average tax burden on income. On the other hand, taxation according to ability, which is implemented through the progressive income tax rate, requires falling average tax rates. In order to guarantee this, the tariff would have to be adjusted with the inflation rate in this case. Cold progression is not – as even some ministers believe – the point of the progressive tariff.

If you want a tax increase, you have to name it specifically

Opponents of withdrawing cold progression point out that the war in Ukraine and the resulting increase in energy prices mean that we are in a special situation in which the state needs more money. The burden of higher energy prices would primarily affect households with low incomes, which cannot be relieved through income tax. Therefore, the withdrawal of the cold progression should be avoided and instead the low income should be compensated by transfer payments. Here, however, the withdrawal of the cold progression – the prevention of a tax increase – is confused with a relief measure.

>> Read here: Comment: Lindner’s tax plans are balanced – and well thought out

In other countries such as Switzerland, the USA, Sweden or France, the income tax rate is automatically updated annually with the inflation rate. This so-called “tariff on wheels” ensures that there are no automatic tax increases and that the political debate can deal with the actual financing needs and their distribution consequences in income tax.

Anyone who then calls for a tax increase, especially for middle and higher incomes, must name this specifically, and a law must then be passed by the Bundestag for this.

Finance Minister Lindner’s approach differs from the previous mechanism for correcting the cold progression, which was based on the publication of the tax progression report. In the past, however, the tax progression report was not a neutral status report, but politically shaped. In the last report from 2020, for example, the partial abolition of the solidarity surcharge was included as a relief measure, resulting in an overcompensation of the burden in the tables.

Relief should come before the heating season

In the current situation, the correction of the cold progression is an important pillar in order to limit the additional burdens on the middle class as a result of inflation. The Federal Ministry of Finance estimates the tariff correction of 5.8 percent inflation at ten billion euros less revenue in the next year.

However, the forecast for the development of inflation will probably be revised upwards with the federal government’s autumn forecast. Our calculation results in costs of a good 15 billion euros for a correction of the entire tariff by 7.5 percent (consensus forecast for inflation in 2022).

A two-part adjustment would also be possible to cushion the additional burden in a timely manner: A correction of this year’s tariff by three to four percent as of October 1st would result in a reversal of the tax increase for all taxpayers via wage tax deduction or income tax advance payment before the heating period. Inflation already causes a loss of purchasing power during the year, so that compensation during the year is justified.

The advantage of this timely adjustment would also be that it can be flanked by the relief measures for low incomes that are undoubtedly required (above all via transfers in housing benefits or social benefits), since the debt brake will not take effect this year. The withdrawal of the cold progression could then be completed by January 1st, 2023.

A short-term alternative relief would be the tax exemption of one-off payments by employers. Rejecting the tax system in normal times would bring about rapid relief in the current situation before the heating period and also reduce the risk of a wage-price spiral.

If 75 percent of the employees received an average of 500 euros, the state would forego tax revenue of an estimated five billion euros, and the revenue forgone from social security would also be around five billion euros. In addition, money will flow back to the state through higher consumer spending through energy and value added tax. That doesn’t change the need to correct cold progression.

The authors: Prof. Dr. Michael Hüther is Director of the German Economic Institute (IW), Dr. Martin Beznoska is Senior Economist for Fiscal and Tax Policy at IW.

More: Who will benefit the most from taking down the cold progression.