The so-called progression reservation is a mechanism to realistically set the tax rate applicable to income taxation. In Germany, this only applies to income tax. Because even if income remains partly tax-free, the taxable income should be taxed according to those standards that would apply if there were no tax exemptions. But is that also fair in any case? We criticize the reservation of progression, especially in the domestic taxation of limited taxpayers abroad.

1. The progression reservation – introduction

The income tax in Germany, as in many other countries of the world, is an income tax in which the amount of the tax rate is variable. Depending on whether you earn little or much income, you pay taxes on these income parts with a successively increasing tax rate. This is related to the performance principle enshrined in the Basic Law. It states that taxpayers who earn a lot should pay proportionally higher taxes than those with lower incomes. The reason for this is that the Basic Law clearly defines that the Federal Republic is a welfare state.

So tax law, especially income tax law, must meet this requirement. And this is done by applying different tax rates to certain parts of income. This is called progression.

But now it is the case that some income parts in Germany can be tax-free, for example, if a person who is taxable in Germany unrestrictedly rents real estate abroad and taxes the rental income exclusively there due to the location principle. If you now determine the amount of income tax in Germany, then on the one hand you could ignore what income remains tax-free. On the other hand, the tax-free share of income can also be used to determine the personal tax rate. However, this increases tax rates and taxes. The latter procedure is exactly what German tax law provides: a taxation under consideration of the progression reservation according to § 32b EStG.

2nd Criticism of progression reservation

This brings us to a first point where criticism of the progression reservation has already emerged in the past. If part of the income is actually to remain tax-free, why do you have to pay a higher tax on other parts of income than actually planned? What remains of the actually permitted tax exemption?

This can already occur with a normal taxation of unlimited taxpayers in Germany. Even without a foreign reference, this is possible in this country. For example, for a shipowner who taxes his income particularly favourably by tonnage tax. If such a shipowner has further income taxable and thanks to tonnage taxation contributes only a small part of the income to shipping despite high actual profit, the personal average tax rate without progression reservation would be significantly lower than what would have to be paid without tonnage taxation. This also applies to other types of income in which there is a state subsidy, for example in agriculture and forestry. But for the part of income that is subject to regular taxation due to taxation after the progression reservation, unusually high taxes then apply.

Granted, these are rare cases. But also apart from this, the progression reservation applies, in particular for wage substitute lines. Unemployment allowance, transitional allowance, short-time work allowance, maternity allowance and parental allowance are just a few examples of tax-free income. Nevertheless, they affect the calculation of the personal tax rate.

Therefore, the question arises whether, just because you receive tax benefits on the one hand, you should then be taxed more heavily on other income than actually provided for by law. However, this is also an aspect which must also be taken into account in the case of persons subject to limited taxation, as we will show in a moment.

Criticism of the progression reservation in the case of limited tax liability

Restricted taxable persons regularly invest their income in the state where they are subject to unlimited taxation and in those where they only have to pay taxes on the income earned there. This creates a dilemma: the performance principle serves a social balance in Germany and is thus intended to secure social peace. But how does this fit in with the taxation of foreigners, who in this country only have to pay low income by applying the progression reservation with a significantly higher tax? Is it justified that the performance principle is still enforced by means of progression reservation? We think that in such cases one may also criticize the progression reservation. Especially when it comes to foreign relations.

Take, for example, Mrs. Calypso from Antigua and Barbuda. There she recorded a high income of EUR 100,000 annually. But she also owns a property in Germany, which she rents annually for just EUR 10,000. In Germany, this is below the threshold of the basic allowance. However, since Mrs. Calypso is not an unlimited taxable person in Germany, she is denied the basic allowance. This can only use unlimited taxable persons in Germany. As a result, it must fully tax the rental income generated in Germany. Under condition of progression. With a total worldwide income of EUR 110,000, the personal tax rate is 42%. So Mrs. Calypso pays EUR 4,200 in income tax. In comparison, an unlimited taxable person would actually have to pay no taxes on these German incomes.

Criticism of negative progression reservation

On the one hand, one can criticize that the progression reservation can lead to higher taxes, even in situations where a higher tax may at least seem unfair. But fairness and morality in general are attributes by which tax laws need to be guided only conditionally; they serve other purposes. On the other hand, a progression reservation can also have the opposite effect. That this should by no means harmonize with the original intention of the legislature should be obvious. But what exactly is meant by the term negative progression reservation and what ignites the criticism?

Let us refer again to our fictitious, in Germany limited taxable Mrs. Calypso from Antigua and Barbuda. At a later point in time, she acquired new properties in Germany, so that she now generates annual rental income of EUR 20,000. At the same time, however, she has recorded a loss of the equivalent of EUR 10,000 in her home country. Using the progression reservation, the tax office reduces the rental income in Germany by the foreign loss amount, so that you have to calculate the personal tax rate on a total income of only EUR 10,000. For income of EUR 10,000, however, a tax rate of 0% applies. Although Mrs. Calypso would actually have to pay an income tax of about EUR 1,800, in this case, due to her foreign losses, she is completely spared before taxes at home and abroad.

Criticism of the progression reservation – Conclusion

At many points one can therefore make criticism of the progression reservation. One must therefore come to the conclusion that the progression reservation is basically only an imperfect approach. He was chosen to meet the requirements of German tax law for a socially acceptable income taxation. It should be clear that the approach is relatively easy to implement. You simply add the tax-free income to the taxpayer and thus determine the tax rate, which is actually justified from the point of view of the legislator. If one wanted to replace this approach with another, one that takes into account the criticism of the progression reservation, one would certainly have to develop much more complex determination procedures. And this always carries the risk that the legislation will come into conflict with other laws, especially the Basic Law. Therefore, it is hardly realistic that the legislator will make an attempt in the foreseeable future to think about a better alternative.

In fairness, however, it must also be noted that the progression reservation is not a unique feature of German tax law. It also plays an important role in many other tax regimes. Especially in large industrial nations with a pronounced income taxation of natural persons, this approach is particularly tempting. For example, the progression reservation is provided for in tax law in the Netherlands, Austria and Switzerland.