Fiscal Drag: Tax Relief – or Simply Avoiding an Additional Burden?

This is precisely the problem described by fiscal drag.

When wages rise in line with prices, income increases on paper. Purchasing power, however, remains unchanged. Without adjustments to the income tax schedule, the average tax burden can nevertheless increase. In other words, people may end up with less purchasing power in real terms despite earning a higher nominal income.

The state can prevent this by shifting tax allowances and income thresholds.

Is that tax relief? Yes. And no.

What matters is the point of comparison.

If the tax schedule remains unchanged, an employee will pay less tax after an adjustment than they otherwise would have paid. Compared with this scenario, offsetting fiscal drag constitutes tax relief.

The picture looks different when we consider the person’s real economic situation.

If a salary has increased only as much as prices have, the employee has not automatically gained purchasing power. If the adjustment merely prevents their tax burden from increasing for this reason alone, they do not receive an additional real economic benefit. At first, it simply prevents an inflation-related increase in their tax burden.

Both statements can therefore be true at the same time: the state provides relief compared with an unchanged tax schedule – while, compared with the person’s real economic starting point, it is preventing an additional burden.

The dispute therefore does not begin with the calculation. It begins with the benchmark being used.

The question remains: does the state have to offset fiscal drag in full?

Germany does not have an automatic mechanism for doing so. Policymakers decide anew each time whether and how the income tax schedule should be adjusted.

Tax thresholds were adjusted for 2025 and 2026. Regarding the planned changes from 2027 onwards, Federal Finance Minister Lars Klingbeil has made clear that a full offset is not envisaged. Lower and middle incomes are to receive more targeted relief, while higher incomes are to face a greater burden.

At this point, fiscal drag ceases to be a purely technical issue.

Because once someone decides how much of it should be offset and for whom, they are also answering a question about distribution.

Certainly, the state has to generate revenue. It has to function and fulfil its responsibilities. At the same time, however, policymakers can decide which income groups should bear a greater or smaller tax burden.

Other countries take a different approach.

International OECD comparisons show that numerous member states automatically adjust elements of their income tax systems for inflation. Austria has adopted a particularly interesting hybrid model: since 2023, two thirds of the calculated volume of fiscal drag has been offset automatically. Policymakers retain discretion over the remaining third.

This changes the political starting point. A large part of the inflation adjustment no longer has to be renegotiated every year – while a portion remains open to political discretion.

An automatic mechanism is therefore not a neutral machine either. Someone still has to determine which measure of inflation applies, which thresholds are adjusted and what exceptions are made.

The political decision does not disappear. It is simply moved to another stage of the process.

So can policymakers speak of tax relief when fiscal drag is offset? The most precise answer is: both descriptions can be correct, depending on the comparison.

Compared with an unchanged tax schedule, the adjustment is a form of relief. People are relieved of a burden because a hidden tax increase is prevented.

For someone whose income has risen only in line with inflation, however, a pure offset initially ensures that their average tax burden does not increase even though their real purchasing power has not grown accordingly.

The term “tax relief” is therefore not wrong. It simply does not tell the whole story.

The underlying question remains: should inflation be allowed to change how much of a person’s income goes to the state in the first place?

Germany has so far chosen not to answer this automatically, but politically.

And that is precisely why fiscal drag is not an insignificant technical detail of the tax schedule. It is a question of how a tax system should deal with inflation, ability to pay and political discretion.

Sources: Federal Ministry of Finance (2024): Questions and Answers on Offsetting Fiscal Drag.
https://www.bundesfinanzministerium.de/Content/DE/FAQ/kalte-progression.html, Federal Ministry of Finance / Lars Klingbeil (2026): Press Conference: Federal Government Draft Budget for 2027 Presented. Transcript dated 6 July 2026.
https://www.bundesfinanzministerium.de/Content/DE/Standardartikel/Video-Textfassungen/2026/textfassung-2026-07-06-bundeshaushalt-2027.html, German Bundestag (2024): Finance Committee Approves Tax Relief from 2025.
https://www.bundestag.de/presse/hib/kurzmeldungen-1034662, ifo Institute (2026): Income Tax Reforms Reduced the Tax Burden by €15 Billion Despite Fiscal Drag.
https://www.ifo.de/pressemitteilung/2026-03-06/einkommensteuerreformen-entlasteten-steuerzahler-um-15-milliarden-euro, ifo Institute (2023): Fiscal Drag in Times of High Inflation: Who Bears the Burden?
https://www.ifo.de/publikationen/2023/aufsatz-zeitschrift/kalte-progression-zeiten-hoher-inflation, OECD (2023): Tax Policy Reforms 2023. Section on income tax reforms and automatic indexation.
https://www.oecd.org/en/publications/tax-policy-reforms-2023_d8bc45d9-en/full-report/component-5.html, OECD (2026): Taxing Wages 2026 – Austria. Description of Austria’s mechanism for offsetting fiscal drag.
https://www.oecd.org/en/publications/taxing-wages-2026_3a5169ef-en/full-report/austria_c6e0a28c.html

AI Transparency