Navigating Trade-offs in German Social Benefit Reform

The current German system of means-tested social benefits, which include citizen’s benefit, housing benefit, and supplementary child benefit, is characterized by high effective marginal tax rates, which are often higher than 90 percent across wide income brackets. As a result, even substantial increases in working hours typically yield small gains in disposable household income. These high effective marginal tax rates apply not only to citizen’s benefit, but also to the housing benefit and supplementary child benefit. Additionally, the coexistence of competing benefits – citizen’s benefit on the one hand, housing benefit and supplementary child benefit on the other – makes the social benefits system complex to navigate for those affected. For these reasons, and against the backdrop of considerable fiscal pressures, there is currently intense political and academic debate about reforming the system.

This study evaluates reform proposals currently under political consideration, categorized into two distinct approaches. The first approach comprises variants of a far-reaching reform in which housing benefits and child benefits are combined with citizen’s benefit and basic income support for the elderly to form a single means-tested benefit that is conceptually modeled on the existing citizen’s benefit framework. Variants within this group differ primarily in earned income exemption design. The second approach represents a more moderate intervention in the existing system: housing and supplementary child benefit are not abolished, but are modified and merged, while adjustments to citizen’s benefit exemptions are introduced. Both reform approaches have in common that they aim to reduce the high effective marginal tax rates in the existing system while simplifying the system for recipients and reducing administrative costs.

We analyze the reform proposals with the behavioral tax and transfer microsimulation model of the Institute for Employment Research (IAB-MSM), which uses household microdata from the German Socio-Economic Panel (GSOEP). The IAB-MSM consists of two components: First, a static tax-and-transfer module that simulates the effects of a tax-benefit reform on the disposable income of individual households, including taxes on income, social security contributions, and public transfers. Second, a discrete choice labor supply model that also endogenously models benefit take-up decisions. We use the IAB-MSM to simulate labor supply effects, fiscal effects, the change in the number of claiming households, and distributional impacts of the reform proposals.

We highlight conflicting goals that must be weighed against each other in political decisions. In particular, “generous” reform scenarios, which attempt to reduce marginal tax rates while ensuring that households are not worse off financially than under the current framework, are generally associated with relatively high fiscal costs. “Restrictive” scenarios, on the other hand, which reduce incentives to work in marginal employment or part-time and strengthen incentives to work full-time, sometimes involve significant budget savings, but are accompanied by income losses for households with low earned income, at least in the short term.