The Removal of the Middle Class Bulge - Models and Costs

Tasks

The current German income tax regime produces a so-called 'middle-class bulge', as the progressive tax rate between 14 and 42 percent does not increase uniformly. Particularly, the intial tax exempt amount is followed by an income bracket between €8,653 to €13,669 in which the marginal tax rate increases sharply from 14 to appproximately 24 percent. In the subsequent, second progressive taxation zone between €13,670 and €53,665, the marginal tax rate then increases at a significantly slower pace, until it finally reaches 42 percent. Due to this characteristic of the income taxation system, it is specifically the middle class that bears the burden of progressive taxation.

This project aims to quantify and economically assess the middle-class bulge, as well as to highlight the potential for reforms.

Methods

The study analyses the middle-class bulge from an economic and politico-economic perspective. It focuses on incentive effects and issues of fair taxation.

The main body of the research evaluates different reform options to abolish the middle-class bulge. It presents possible adjustments of the tax scale, whilst distributive effects on the taxpayer's side and changes in tax revenues are simulated. The resulting fiscal strains and reliefs for taxpayers are measured dependent on individual income as well as on aggregate levels. Morerover, the aggregate consequences on real earnings and GDP potential are estimated.

Data and other sources

Microdata of the wage and income statistics (State Statistical Offices, Federal Statistical Office)

Results

The project results were presented by Clemens Fuest at a press conference in Berlin on 02.12.2016.

The middle-class bulge is responsible for a rapidly rising marginal tax rate for low and middle-income earners, which is why the middle classes are often seen in the public debate as the part of society that finances a particularly large share of state expenditure.

Possible approaches to flattening the middle-class bulge are to gradually shift the income benchmark that marks the beginning of the second bracket (reform option I), to shift the income threshold for the top tax rate (reform option II) and a combination of both of these options with a parallel shift in both thresholds (reform option III). The impact of these reform options are assessed using the Ifo income tax simulation model (Ifo ESM).

For reform option I the calculations of a “moderate” flattening in the middle class bulge (a benchmark shift of 5,000 euros) would result in tax relief totalling 15.7 billion euros. A complete flattening of the middle-income bulge (a shift of 11,011 euros in the bracket benchmark) would generate tax relief of 31.4 billion euros. Although all taxpayers would be better off, the high-earning middle class in the seventh income decile with a gross income of between 31,993 euros and 62,447 euros would stand to benefit the most in relative terms.

The relief effect of reform option II for a “medium” shift in the income threshold by 5,000 euros for the top tax rate amounts to 3.7 billion euros. A “stronger” shift in this figure (of 25,000 euros) would result in tax relief of 14.7 billion euros. The individual relief effect of reform option II shifts slightly to the benefit of higher income earners and is relatively strongest in the eighth income decile for individuals with gross earnings of 62,448 euros to 113,532 euros.

The combination of both shifts in reform option III featuring a “moderate” shift in both figures of 5,000 euros would generate tax relief of 19.0 billion euros, which would mean that the tax ratio could remain at around the level of 2014. A “strong” shift in both figures of 11,011 euros would result in tax relief of 37.0 billion euros. Under the third reform option individual relief effects are far greater than in the previous scenarios. It is nevertheless not the top earners, but individuals in the eighth income decile with a gross income of 62,448 euros to 113,532 euros who stand to benefit the most from the tariff reform.

This study was also published in the “Ifo Forschungsberichte” series.

Publication (in German)

Dorn, Florian, Clemens Fuest, Björn Kauder, Luisa Lorenz and Martin Mosler, Die Beseitigung des Mittelstandsbauchs – Varianten und Kosten, ifo Forschungsberichte 77, ifo Institut, 2016 | PDF Download