How should the tax wedge on labour income be assessed? This is a frequently discussed topic in Germany. A large tax wedge reduces incentives to work and potentially exacerbates the economic challenges caused by skilled labour shortages and demographic ageing. An article from the Bundesbank’s current Monthly Report therefore examines the individual components of the tax wedge ratio in more detail and sheds light on the German tax wedge in an international comparison. 

The varying degrees of “net”: the tax component differs from the retirement savings component 

The discussion about the tax wedge ratio on labour income mostly focuses on the tax wedge ratio as a whole. However, this is made up of different components. “A nuanced analysis of tax wedge ratios makes an important contribution to enabling better interpretation of tax wedges,” the authors of the article write. This applies both to purely national analyses as well as to international comparisons, they note. 

The Monthly Report article therefore decomposes the tax wedge ratio into two components: the retirement savings component and the tax component. The tax component covers levies that do not directly result in individual benefits – such as wage tax payments. The retirement savings component is the part of pension contributions that grants old-age retirement benefits based on contribution equivalence. Although higher pension contribution payments initially reduce insured persons’ net wages in the same way that a tax does, they also increase their pension entitlements. According to the authors, such equivalence-oriented pension contributions are often more akin to an investment in a compulsory pension scheme than a wage tax payment. They should thus dampen incentives to work to a lesser degree than taxes.

The authors caution against reading too much into the quantitative results of this article, as the equivalence-oriented pension contributions are estimated here based on OECD data using a schematic and highly simplified method. The methodology may therefore be refined in the future. What the article does illustrate, though, is that the retirement savings component of the tax wedge is sizeable in many countries. 

In many countries, the tax component of the tax wedge is markedly smaller than the total tax wedge

The authors report that, given the large retirement savings components of pension contributions in many countries, the tax component of the tax wedge is significantly smaller than the total tax wedge. On average across the countries under review, the tax component of the tax wedge is 15 percentage points lower than the total tax wedge ratio. Thus, the tax component of the tax wedge ratio for single persons earning the average wage with no children is around 27%, while the total tax wedge ratio is around 41%. For couples with one average wage earner and two children, the tax component of the tax wedge ratio is around 15%, compared with around 30% for the total tax wedge ratio.

This applies to Germany, too, with the country ranking relatively high for both the tax component of the tax wedge ratio and the total tax wedge ratio in a cross-country comparison

According to the article, the tax component of the tax wedge ratio is significantly lower than the total tax wedge ratio in Germany as well. The gap roughly corresponds to the average of the countries under review. In Germany, the tax component of the tax wedge ratio and the total tax wedge ratio are above average by international standards. This particularly applies to single persons and households with two earners. For multi-person households with one earner, Germany’s position in the ranking is more favourable. 

It is important that insured persons have confidence in the pension system

With regard to assessing the retirement savings component of pension contributions made by insured persons, it is crucial, amongst other things, that they have confidence in the long-term sustainability of the pension system. According to the article, this is necessary for pension contributions to actually be perceived as retirement provision rather than tax. Against this backdrop, it is important to ensure the pension system is financially sustainable. Insured persons should also be provided with enough information on their future entitlements and how they relate to their contributions. For countries with pay-as-you-go systems, a sound macroeconomic path is particularly important. Such a path is the main determinant of the amount of pension entitlements granted by contributions. “Economic and fiscal policymakers are thus also called upon to ensure favourable business conditions and growth prospects in their countries,” the authors write.