Top Tax Progression and the German Dual Income Tax

This paper analyzes the effect of the introduction of a final withholding tax on capital income on the progressivity of the German income tax. In 2009, capital income was excluded from the synthetic income tax tariff. Since then, it has been taxed at a lower final withholding tax rate. This paper explores the effect of this change on vertical and on horizontal equity, with a particular focus on top income groups. Both the direct static reform effect and the reform effect with adjusted reporting behavior are simulated. The analysis is based on a micro-level panel dataset of income tax returns between 2001 and 2006 that is particularly representative for the top of the income distribution. This data provides information on synthetic incomes including capital income. The panel structure is used to construct a permanent reform effect that is less prone to annual volatility in income composition. The reform is found to be regressive, as it virtually does not change net incomes below the top 5% threshold. Within the top of the distribution, the gain in net incomes is spread widely, but is not negative under plausible assumptions on reporting adjustments.