Reform of Personal Income Tax

Revenue has risen by 50 percentage points more than the wage bill over recent years, indicating a higher overall tax burden.

As a result of these missing reforms, marginal tax rates rise to a high level at a relatively low income. The top tax rate also applies much earlier relative to average income than it did in the past. High marginal tax burdens reduce the incentive to work longer hours. Combined with social security contributions, up to 60 percent of an additional euro of employer labour costs is absorbed by the state.

At the same time, personal income tax affects the willingness to take entrepreneurial risk. It does not only apply to employees but is also an important business tax. Partnerships account for only about 2.4 percent of taxpayers, yet they generate around 14 percent of total income. Any debate about raising the top tax rate or the surtax on very high incomes should therefore take into account that this would significantly affect entrepreneurial activity. Around 40 percent of the tax base subject to the top rate stems from business income; for the surtax on very high incomes, the share is as high as 70 percent.

At the same time, personal income tax plays a central redistributive role. Lower income groups pay little or no income tax, while the burden rises sharply with income. The top 5 percent of taxpayers account for around 40 percent of total revenue from personal income tax and the solidarity surcharge, while their share of taxable income is only just under 22 percent.

A full elimination of the so-called “middle-class bulge” would be a far-reaching reform and, from the perspective of work incentives, a desirable one. However, with revenue losses of around 68 billion euros, it would be fiscally very costly. A more moderate reform therefore appears more realistic – one that relieves low and middle incomes and shifts the threshold for the top tax rate to a higher level. This option is estimated to reduce revenue by around 21 billion euros. For average earners, this would amount to annual tax relief in the mid-hundreds of euros. The fact that the amount rises with income is inherent in the structure of the tax schedule. Such a reform would largely reverse the gradual tax increases of the past 20 years and roughly restore the tariff structure of 2006, i. e. after the last major income tax reform.

Although all income groups would benefit from the reform options, high-income taxpayers would still bear a larger share of the total tax burden than they do today. The reason is that middle incomes in the linear-progressive part of the schedule would be relieved more strongly in relative terms than high incomes. It should also be noted that merely offsetting bracket creep in 2026 already requires tax relief of around 8 billion euros. Only measures beyond that would amount to structural relief.