Why is inflation like a tax

Cold progression simply explained - with an example

The Federal Ministry of Finance explains the cold progression as follows: “One speaks of cold progression when income and wage increases only compensate for inflation and there is an increase in the average tax burden despite unchanged performance.” You only understand train station? No problem. We'll explain it to you.

The term cold progression means, in very simplified terms, that although you have received a raise, you can afford less than before. Two factors are to blame for this phenomenon.

  1. The tax progression: the more salary you earn in Germany, the higher the tax rate climbs.

  2. Inflation: The prices of goods and services are rising continuously. Ultimately, this means that the purchasing power of money will decrease at the same time.

The tax burden is growing faster than gross income

An example makes the principle of cold progression more tangible: Ina is single in tax class I and earns 3,500 euros gross per month. Her boss is happy with her job and is giving her a three percent raise in 2021. That is at least 105 euros, which Ina gets more gross every month. However, only 53.79 euros remain net of the 105 euros. Because while Ina's gross salary increases by three percent, her net salary only climbs by 2.3 percent.

This is because Ina has to pay a higher tax rate with an income of 3,605 euros than with 3,500 euros. The tax burden is growing faster than gross income. In figures: Ina's average tax rate has increased from 14.99 percent to 15.33 percent (excluding church tax) as a result of the salary increase.

So we keep in mind: As a rule, with a salary increase due to the tax progression, the net salary increases less than the gross salary. We come to the second factor, inflation.

Goods and services are usually becoming more and more expensive

Whether shopping in the supermarket or refueling at the gas station, goods tend to get more expensive year after year. That's because of inflation. The price increase is measured using the inflation rate. And that was 1 percent in January 2021, for example. If Ina subtracts the inflation rate from her 2.3 percent net salary increase, only 1.3 percent salary increase remains in real terms.

If the boss only compensates for the inflation rate, cold progression arises

A mind game: Let's assume that Ina's boss hadn't increased her salary by three percent, but only offset the inflation rate. Your salary has increased by 1 percent or 35 euros. Instead of 3,500 euros, she now receives 3,535 euros.

If this went on for several years in a row, she would suffer a real loss of income. As the? Well, Ina's net income increases more slowly than her gross salary due to the tax progression. But that also means that their net income is growing more slowly than inflation. So Ina can actually afford less despite the increase in her salary, her purchasing power drops - that is the cold progression.

By the way:

The cold progression is sometimes referred to as a creeping tax hike or a clandestine tax hike.

Cold progression hits especially low and middle earners

Low and middle income people in particular suffer from cold progression. This is due to our income tax system: Income of up to 9,744 euros per year - this is the current basic tax allowance in 2021 - are tax-free. But already the 9,745th euro is taxed at 14 percent. After the basic tax-free allowance, the progression curve is initially quite steep before it flattens out.

Top earners in particular benefit from this flattening: from an annual income of 57,919 euros (as of 2021), the tax rate remains constant at 42 percent. Therefore, the cold progression has significantly less effect on high earners.

Abolish cold progression

No wonder, then, that the cold progression is always hotly debated, especially during election campaign times. The call for more fair taxation is regularly greeted like a groundhog.

One way to mitigate the cold progression is quite simple. Politicians would have to adjust the tax rate annually to the inflation rate. Other countries do the same, for example the USA, France or Switzerland. The taxpayers' association even goes one step further and calls for the income tax rate to be put “on wheels” - that is, automatically adjusted to both price and wage increases.

Opponents of a tax reform argue that such adjustments bring little to the individual citizen, but cost the state a lot. For some politicians, the currently relatively low inflation rate is reason enough not to want to tackle the issue of "abolishing the cold progression". So we can be curious to see how it goes from here.

 

This is an editorial text from the VLH editorial team. There is no advice on topics that are outside the tax advisory powers of an income tax aid association. Consulting services in specific individual cases can only be provided within the framework of the establishment of a membership and exclusively within the advisory authority according to § 4 No. 11 StBerG.