Conversion of tax allowances to credits - effects on tax relief and employment in Germany

If the basic tax-free allowance in income tax in Germany were completely converted to a tax credit, the lower income groups would benefit more from it, but employment would fall. This is the result of a model calculation carried out by the ifo Institute on behalf of the Center for New Social Policy (ZSP) in Berlin. “Tax-free allowances reduce the income that has to be taxed for everyone. As a result, the absolute tax benefits are particularly high in higher income groups, because the marginal tax rates are higher there. The credits, on the other hand, are direct deductions from the tax payment and could also be extended to lower groups that have not yet benefited from tax allowances, because they do not pay income tax. However, the employment effects would be strongly negative,” says Andreas Peichl, Director of the ifo Center for Macroeconomics and Surveys.

“Our study illustrates how increases in the tax-free allowances in the current system provide less relief for people on low incomes,” says Mansour Aalam, Director of the ZSP. “The linking of the tax and transfer system modeled in the study can provide a basis for thinking about the pressing problem of non-utilization with experimental ideas.”

Co-author Maximilian Blömer says: “Switching completely to credits, as in the US, is not easy in the complex German system because many things are interrelated.” The tax-free amount is currently around EUR 11,000. This is set to zero in the model and a tax credit is paid out instead. For example, an annual credit of EUR 1,527 would give the state additional revenue of EUR 84.4 billion, while a credit of EUR 4,581 would reduce revenue by EUR 107.2 billion. Switching completely to credit would be neutral at EUR 2,820.

“However, a revenue-neutral switch to credits would result in significantly fewer people working, to the tune of around 550,000 full-time jobs. In addition, 400,000 people would leave the labor market.”

On average, the basic tax-free allowance provides relief of more than EUR 4,000 annually (around 9.6 percent of disposable income) per household. Absolute relief rises continuously as taxable income increases. In relative terms, the middle class (third to eighth decile of income) benefits the most from the basic tax-free allowance, with effects of more than 10 percent on disposable income. Absolute relief for couple households is more than twice as high as for households with only one adult.

The study also examines the reciprocal effects on mini-jobs, social benefits and marital splitting.