Income tax in Germany is designed to distribute tax burdens according to the ability to pay, which is why it is a progressive tax scale – higher nominal incomes attract a higher average tax rate. If prices rise while the tax rate remains unchanged, this leads to “hidden” tax increases or “bracket creep”: the tax burden rises relative to real income. Yet real income is a better reflection of a taxpayer’s ability to pay, given that it is adjusted for inflation and therefore indicates how many goods and services can be purchased with it.

To prevent bracket creep, legislators have, at broadly regular intervals since 2013, adjusted the tax scale for the expected inflation rate with a one-year time lag. “While inflation was not always perfectly compensated for in every single year as a result of this, it was more or less offset overall,” the Bundesbank writes. Owing to the strong rise in prices last year, bracket creep significantly exceeded the tax relief in 2021, while the two years before that saw opposing effects materialise that were of a similar magnitude overall. As the inflation rate this year is very much higher still, the Bank’s experts are expecting bracket creep to total around €13½ billion for the current year. That significantly exceeds the adopted tax relief measures in 2022. The Bundesbank’s economists see two reasons for this development: the tax scale is only adjusted with a time lag, and underlying inflation was underestimated in 2021.

Current procedure could be improved

Pointing to recent developments, the Bank’s experts explain that the procedure used at present does not compensate for bracket creep in a targeted and timely fashion. These aspects are not of any great significance as long as inflation rates are comparatively stable, they note, but fluctuations and sizeable estimation errors cannot be ruled out now or in the future. “This is why the procedure is bound to lead to compensation decisions now and again in the future that are not a perfect fit,” the economists write.

The experts therefore recommend that tax rates be reviewed annually in future, rather than every two years as hitherto, and shifted as necessary. According to their proposal, every autumn the tax scale for the coming year should be adjusted based on the government forecast for next year’s inflation rate. That way, it would be possible to account in a more timely manner for unexpectedly volatile price increases or an exceptionally high rate of inflation. Estimation errors could be offset in the next round of adjustments to the tax scale.

Greater transparency in financial planning desirable

The experts also note that bracket creep does not open up any additional financial scope if it is regularly compensated for. As long as fiscal policy sticks to its current approach, it would therefore be logical for central and state governments not to budget for such revenue – not even in their medium-term financial plans. At present, it is not always clear what revenue has been specifically included in their financial plans in this regard. On a very general note, the experts propose conducting a more thorough examination of the tax system from time to time in order to assess, for example, whether its effects on the incentives to work and the distributional effects are still calibrated appropriately.