With recent discussions on changes to the German income tax law, especially regarding the splitting regulation for couples and families, I grow continuously frustrated at politicians’ inability to simplify the tax code. And it could be so easy.
Initial Considerations
Unfair Ideal of Fairness
It’s a recurring issue of tax codes that they put a lot of effort into attempts of being fair. Most exceptions and loopholes in tax systems are there to remedy a perceived unfair situation for someone. Every single one of them can be argued for and makes sense in isolation, but in total, they add up to a system that is so complex that you need specialists to understand it, which is simply unfair towards those who can not afford the specialists—the less wealthy.
But to fix this, you need to get rid of regulations every single one of which helps someone out there, so every simplification will upset someone. And that is something politicians would rather avoid. So we are stuck with a horrible system.
Because of this, for every proposed system improvement, someone will complain that it will treat them worse than the old system. So any discussion about a new system should discuss specific parts of the system on its own, and only ever the whole system in comparison with the old.
Progressive and Regressive Tax Systems
Most income tax systems are progressive, meaning that people with a higher income pay a higher tax rate than those with a lower income. While the idea that this would lead to situations where earning more results in actually receiving a lower absolute amount due to higher tax rates is false as this is specifically avoided in most tax systems, this can still be perceived as unfair: Why do some people pay a higher percentage of their income and some people pay a lower percentage than others, just because they earn more or less?
The reason for this is a result of the marginal utility of money. The first Euro has a much higher value than the one millionth Euro. Specifically, there is a certain amount of money that everyone needs to pay just to survive. This includes basic food, housing, and clothes. Let’s say you need 500 EUR per month for that. If someone makes 500 EUR a month, and another 2000 EUR a month, charging a flat 25 % tax rate would leave the former with too little money to get by, while the latter can easily afford it. This is can not be called a “fair” tax in any way.
The same argument can be extended. Above this subsistence level, there’s a level of comfortable living, versus luxurious living. There’s a difference in unfairness between making the only vacation someone might have in a year impossible, versus making the fifth vacation impossible.
If you start with a tax level, any tax level, for the richest people, each of those steps means that it would only be fair if the group earning less than the current group should pay a smaller percentage of their income in taxes. So maybe we should talk about lower taxes for poorer people, not higher taxes for richer people. It means the same, but might make more sense to some.
There’s a second reason for a progressive income tax, and that is that the other major tax, the value-added tax or sales tax, is inherently regressive. That is, the higher your income, the smaller the percentage of it is paid to that tax. This is because the more income you have, the smaller the percentage of it you pay for goods with a sales tax. The income tax is the only tax that can be easily adjusted to be progressive, so it can be argued that this is useful to balance out the inherent unfairness of the other taxes.
A progressive tax system does not only have advantages, though. Such a tax formula makes tax calculation more complicated, making it difficult to know beforehand how much of a pay raise will actually be available for you.
But the biggest problem for progressive tax system appears when you consider tax deductions.
Deductions
A tax deduction is any amount of money you deduce from your income before applying the tax formula. Tax deductions are usually the most complicated part of any tax system, as it’s the easiest place to give a special consideration for specific situations that are deemed to be treated better by the state.
In a progressive tax system, tax deductions are necessarily regressive. The same amount of deduced money results in a larger amount of saved money the more you earn. This is a completely silly effect, considering that many of the tax deductions are meant to help poorer people especially.
In a progressive tax system, it is therefore much more sensible to reduce the tax debt after applying the tax formula, as that helps everyone the same.
Goals
With these considerations, the goal for my income tax system is primarily the redistribution of wealth to ensure that no one has to live under the level of subsistence. While every bit of money earned must result in a higher net income to encourage finding work, this must not mean that anyone has to fear total poverty.
Beyond this primary goal, ruling parties can use the tax system to get money for other projects, depending on their governmental philosophy.
Income Tax System
Types of Income
This system recognizes four types of income: Wages, profits, investment, and a catch-all for other income.
Wages are from employment contracts where the wage is considered an expense for a corporation or other employer, that is, where someone else deduced the wage from their income before taxes. This avoids double taxation. Legally required social security payments that are withheld from the employee (jobless security, accident insurance, etc.) are deduced from the income before taxes. Additionally, there is a fixed deduction to account for private expenses related to getting and keeping a job (currently 1,000 EUR in Germany). Making this a fixed sum avoids a lot of complexity and special cases, at the expense of some people with exceptional expenses being worse off.
Profits are from self-employed work, non-incorporated firms, rent or leasing. In all of these cases, there are clear expenses related to the relevant income. The taxable income from profits amounts to the total income thereof minus the appropriate expenses. There are no other deductions. This is probably the most complex income type, as it requires definitions of what constitutes appropriate expenses. Reforming this complex system in Germany is a matter for another post, though, as it ties in with other business-related laws.
Investment covers all income made by lending money for interest, anything from saving accounts to shares and stocks. This income has a fixed deduction to protect small private savings (currently 801 EUR in Germany), and no other deductions. Investment income is tricky. It is the most volatile income type, and can quickly move to other countries. A common approach, implemented recently also in Germany, is to keep this type of income completely separate from all other income types and apply a flat tax rate to encourage investment. The proposal here follows that approach, as it is extremely simple and easy to enforce.
Other income then includes every other source of income. Typical examples are pensions, larger private sales, etc. These regularly have specific laws defining them somewhere, and rarely have exceptions or loopholes. For example, currently in Germany, pensions have a fixed deduction of 102 EUR; similar fixed deductions can be defined for other categories if necessary. As another example, private sales below 600 EUR do not need to be included. This is not a deduction; if you sell something for 601 EUR, your taxable income increases by 601 EUR from this sale. This is regularly a surprisingly simple part of income tax law, so not really necessary to simplify much.
Deductions
Sadly, due to historical reasons in Germany, further tax deductions can not be avoided completely. The sum of the income above therefore has to be further reduced by a small and well-defined set of deducible expenses.
In Germany, this has to include private retirement provisions (e.g. “Riesterrente”). Also, donations to charities have a longstanding tradition of being tax-exempt to encourage donations, so that likely has to be kept as well.
All other deductions should be abolished and transformed into tax debt deductions.
Tax Debt
The result of the above is subject to a tax formula and yields the tax debt. The details of the tax formula are one of the easiest and most effective places for the ruling parties to adjust this system.
Investment income is taxed completely separately from the rest at a fixed and flat tax rate, again subject to the ideas of the ruling parties. Currently, this would be 25 % in Germany.
Tax Debt Deductions
The resulting tax debt can be further reduced, down to 0, by whatever other means the ruling parties consider necessary to support specific situations. I’d recommend to keep this to a minimum, and I won’t provide any recommendations, but it’s a possible way of adjusting the system if deemed necessary.
Subsistence
The resulting tax debt then is directly reduced by the subsistence level of the tax payer, and the subsistence level of any children in their custody (only for one parent, obviously). This is special in that it can reduce the tax debt below zero, in which case the tax office pays out money instead of charging it. This unifies long-term jobless payments (ALG II), social help, student loans, and various tax-free subsistence levels of the income tax into a single, well-understood system.
Subsistence levels are calculated by an appropriate method. Currently in Germany, this uses average expenses of families with a specific income level, but I’m open to improvements there. What is important is that this results in a general subsistence level for adults and children, for everything but housing (currently 4,584 EUR in Germany for adults)
The cost of housing varies drastically between regions, and as such is defined by the municipality the tax payer lives in. This uses a percentage of the average rent for a single person in the municipality. Contrary to the current ALG II method the value is independent of the actual expenses to reward finding cheaper housing.
The general subsistence level is paid by the state while the housing is paid for by municipalities, at least to some percentage. This encourages municipalities to implement regulations that provide affordable housing to keep this cost down.
With subsistence levels covered like this, the progressive income tax rate can start at 0 EUR income and can be quite steep (say 50 %) until the subsistence payments are balanced out.
The subsistence levels are again a way where the ruling parties can influence the system without making it much more complex. As a good example, disabilities could increase the subsistence level to some degree.
Other deductions of the German tax system should almost all be abolished. Single parents should already have a sensible basic level of support by the above, any further money should go into the availability of cost-free day care facilities, as these provide work and allow parents to work as well. Likewise, school and education expenses should not be handled on the level of the income tax but subsidized to schools and universities directly.
Example Calculation
The numbers here are just examples, obviously. Exact numbers can be adjusted by policymakers as necessary.
Let’s say there’s Tom. Tom currently has no job. The subsistence level is at 4,584 EUR and the subsidized housing cost in his municipality is 3,546 EUR a year, resulting in 8,130 EUR a year of total subsistence cost. He goes to the tax office and notifies them that he expects no income this year. The tax office then will transfer 678 EUR a month to his account.
A few months and many job applications later, Tom actually is hired for one day a week, earning 300 EUR a month. His employer notifies the tax office, which calculates that Tom’s total taxable income will be 3,600 EUR a year, minus the fixed 1,000 EUR deduction being 2,600 EUR. The tax is set so that initial tax rates are at a steep 50 % until the tax debt is zero, after which a multi-bracket system starts with 10%, going up again as the taxable income increases. So right now, he pays 50 % taxes, or 1,300 EUR. But that tax debt is again reduced by his subsistence level of 8,130 EUR a year, still resulting in 6,830 EUR payment from the tax office, or 570 EUR a month. This means that Tom now earns 870 EUR a month, or 192 EUR more than before. Even his small amount of work paid off.
The more work Tom finds, the more money he will have in the end, even though added payments from the tax office go down. Due to the 50 % initial tax rate, he gets monthly transfers from the tax office until he earns 17,260 EUR a year, or 1,439 EUR a month. Incidentally, this is just below the full-time pay of someone earning the minimum wage of 8,50 EUR currently being discussed (17,740 EUR). At that point, every further euro earned is taxed by 10 % and up to the next bracket, etc. as usual.
Expanding the System
This system has a few well-defined and clear places where different governments and parties can adjust it to fit their political idea.
The subsistence level can be changed up and down depending on the ruling parties’ ideas of how much encouragement people need to work. The tax levels and brackets can be adjusted depending on how high the tax burden on the citizens should be, or how progressive the tax should to be. These are all simple but effective ways of adjusting the system to a political agenda without making it any more complex than it is.
Still, I fully expect certain corner cases to crop up that this very simple system does not cover well at all. Those would either add undue burden to citizens or not respect certain aspects of the constitution. Such special cases should be added as tax debt deductions if at all possible, and be kept as simple as possible, favoring lump sums and flat rates over detailed calculations.
But in any case, I’d like to caution against adding complexity. The tax system affects everyone, and the more complex it is, the more difficult it is for everyone to deal with it. Try to add things only if absolutely necessary.
And most importantly, the income tax system is not a place to reward or punish specific activities. Doing so only complicates things for everyone. Many of the current special cases in Germany are so-called “tax presents” for special groups. Don’t fall for this again in the future. Instead of income tax changes, add specific bonus payments or investments by the state for such activities. This is not much more complicated for the individual requesting them, but much simpler for the rest.
Summary
I have proposed a very simple tax system which ensures that every citizen can live above subsistence level. Additionally, the tax system ensures that every bit of income increases the available income, giving strong incentive to all citizens at all times to find more work.
The system also provides a number of well-defined regulatory settings that the government can use to adjust it to their philosophy without increasing the system’s complexity at all.
If implemented in Germany, this system could replace the current income tax, the long-term jobless help (ALG II), social help systems, child money, education aid (BAFöG) and a number of other ways in which the state tries to help people in need, reducing administrative costs tremendously.
But the simplicity has some problems. Simplifying a tax code always results in some situations being more unjust than before. Sometimes, a small injustice has to be accepted to avoid undue complexity. But if the injustice is too large and no solution can be found outside of the income tax code, it is still possible to adjust this system. But it’s preferable to do this outside of the income tax to keep complexity down.
