106 -0,8% -0,6% -0,4% -0,2% 0,0% 0,2% 0,4% 0,6% -1 -0,5 0 0,5 1 1,5 2 2,5 3 3,5 4 4,5 REAL GDP GROWTH (AVG. P.A., LEGISLATIVE PERIOD) FI SC A L EF FE C TS O F TA X R EF O R M S (L EG IS LA TI VE P ER IO D S, A VG . P .A .) GDP GROWTH AND TAX REFORMS -1990 -1980 -1972 -2002 -1987 -1976 -1994 -1998 -1983 -1969 over GDP % Own calculations based on: Federal Ministry of Finance (2004)/Federal Statistical Office(2007).Data on adopted tax reforms. Figure 49: Real GDP growth and tax reforms (based on legislative periods) 2.2 Tax reforms as a reaction to cold progression 2.2.1 General approach and hypotheses From a normative point of view, inflation can be linked to tax reform as well. In the progressive wage and income taxes (which are not inflation-indexed in Germany) inflation pushes up the tax burden by “bracket creeping” or “cold progression”: the nominal and real tax burden of individuals increases without tax policy changes, as wage and income inflation increases the applicable tax rates. Based on this cold progression one could expect that many tax reforms are just a reaction to inflation, moderating or even offsetting inflationary effects on the tax burden in the progressive wage and income taxes. Based on the mechanism of cold progression we would expect that the overall tax burden in the progressive wage and income taxes is reduced stronger in times of high inflation (cold progression hypothesis 1). Furthermore, we would expect that especially tax reductions in wage and income taxes are larger in times of high inflation (cold progression hypothesis 2). 107 2.2.2 Empirical tests of tax reforms as reaction to cold progression To test the influence of cold progression on tax reforms, we start with an examination of overall fiscal effects of tax reforms in the progressive wage and income taxes. Based on our data-set we have calculated the average annual fiscal effects of tax reforms in wage and income taxes and the average inflation rate (measured by the GDP-deflator)188 for all 10 legislative periods covered in our data-set. We decided to focus on the analysis of tax policy in legislative periods and not in single years, as these data are best suited to reflect the overall government strategy in tax policy.189 -1,0% -0,8% -0,6% -0,4% -0,2% 0,0% 0,2% 0 1 2 3 4 5 6 7 8 INFLATION (LEGISLATIVE PERIODS, AVG. P.A. ) FI SC A L EF FE C TS O F TA X R EF O R M S IN W A G E A N D IN C O M E TA XE S (L EG IS LA TI VE P ER IO D S, A VG . P .A .) -1990 -1980 -1972 -2002 -1987 -1976 -1994 -1998 -1983-1969 over GDP % COLD PROGRESSION AND REFORMS IN WAGE AND INCOME TAXES Own calculations based on: Federal Ministry of Finance (2004)/Federal Statistical Office(2007).Data on adopted tax reforms. Figure 50: Inflation and net fiscal effects of wage and income tax reforms Figure 50 maps the relationship in between inflation and the overall fiscal effects of tax reforms in the progressive wage and income tax. In the graph we see that the correlation in between tax reductions in the wage and income tax and inflation is not strong and the relationship is reverse to the one expected based on cold progression: 188 Alternatively we have conducted the analyses by using the consumer price index to measure inflation and have derived very similar results. 189 However, annual data shows very similar results. 108 Low and not high inflation is correlated with reductions in the overall tax burden in wage and income taxes. Therefore, we find no evidence for our cold progression hypothesis 1 in the data. However, the overall development might not be the best indicator as cold progression might only have an effect on tax reductions. Therefore, we separated the average annual extent of tax burden reductions via tax reforms (see Figure 51). Here we find a similar relationship as before: low inflation is correlated with high tax burden reductions in wage and income taxes. This again strongly contradicts the hypothesis of a direct influence of cold progression on tax reforms.190 Based on our results, cold progression cannot be seen as a main driving force of the tax reforms discussed here as inflation is not linked to tax burden reductions via tax reforms in wage and income taxes.191 COLD PROGRESSION AND REDUCTIONS IN WAGE AND INCOME TAXES -0,9% -0,8% -0,7% -0,6% -0,5% -0,4% -0,3% -0,2% -0,1% 0,0% 0 1 2 3 4 5 6 7 8 INFLATION (LEGISLATIVE PERIODS, AVG. P.A. ) FI SC A L EF FE C TS O F TA X R ED U C TI O N S IN W A G E A N D IN C O M E TA XE S (L EG IS LA TI VE P ER IO D S, A VG . P .A .) -1990 -1980 -1972 -2002 -1987 -1976 -1994 -1998 -1983 -1969 over GDP % Own calculations based on: Federal Ministry of Finance (2004)/Federal Statistical Office(2007).Data on adopted tax reforms. Figure 51: Inflation and fiscal effects of tax reductions in wage and income taxes 190 An examination of the pattern of wage and income tax reforms supports our finding (see part IV.2.1). For example, the first strong tax burden reduction in wage and income taxes took place in 1975 while there was no substantial reduction in the high-inflation years in between 1964 and 1975. 191 Our findings are in line with the observation that there were no serious attempts to implement inflation indexing in Germany. This shows that there was no political will to compensate tax payers systematically for tax increases caused by cold progression. 109 2.3 Tax smoothing Based on Barro (Barro 1979, 1986) one can argue that it is suboptimal for governments to react to transitory changes in economic growth and fiscal deficits by changing tax policy. As the excess burden of taxation and the adjustment costs – given the same level of public revenues over time – would be substantially higher in case of frequent changes of tax regulation, a “tax smoothing” would lead to less economic distortion. What pattern of tax policy would we expect to observe if governments would follow the theory of tax smoothing? First, we should not see a direct influence of economic growth or fiscal deficits on tax reforms. Furthermore, we should observe only a very limited number of tax reforms over time as tax policy should focus on structural developments and avoid frequent changes which trigger high adjustment costs for the economy (tax smoothing hypothesis 1). If we look at the very stable revenue structure (see part II), we could be tempted to believe that tax smoothing considerations played an important role in German tax policy. And even the finding that tax reforms were not closely linked to macroeconomic developments might speak in favor of tax smoothing. But a closer inspection of our tax reform data-set leads us to a different conclusion. Although the overall revenue structure was very stable, the tax system was permanently changing. Based on our data-set we found that there were more than 1,000 changes in tax regulations within 40 years and the total cumulated fiscal effects of all tax reform changes covered here accounted for more than twice the average annual tax revenues in Germany (see part III and part V.3.2). Such a strong activity in tax policy is not at all compatible with the theory of tax smoothing. Therefore, we argue that our data speak strongly against the hypothesis of tax smoothing. 2.4 Summary of findings In this part we have analyzed the explanatory impact of normative approaches on tax reforms in Germany from 1964 to 2004. Based on our analyses of annual data as well as of data for each of the ten legislative periods covered in our data-set, we found only very limited support for normative approaches of tax policy. Our data show that the stabilization function played no role in tax reforms as the pattern of tax reforms was not linked to real GDP growth. Furthermore, we found that high inflation did not lead to higher tax burden reductions in the progressive wage and income tax. This indicates that German governments did not attempt to correct for cold progression in wage and income taxes via tax reforms. Finally, the high number and extent of tax reforms throughout the period 1964 to 2004 speaks against the theory of tax smoothing.