Tax Advisor Explains: What Is Cold Progression?

As you climb the career ladder, you may find yourself looking forward to a raise. In most cases, a pay raise is equated with a higher net salary. However, it is often overlooked that a pay raise can actually result in you having less money at your disposal. In this context, you may have already heard the term “bracket creep.” As tax advisors in Düsseldorf
and Oberhausen
, we frequently find that clients have given little thought to this topic. In this article, we therefore aim to clearly explain what “cold progression” is and what it means for your finances.

Basics – How Are Taxes Levied?

First, let’s look at the starting point. In Germany, income exceeding the basic exemption of €9,408 is subject to taxation. The amount of tax is determined by a tax rate. Therefore, higher income results in higher taxes. Every employee should be aware of this much. However, how the tax rate is calculated is often overlooked. The tax rate is generally adjusted progressively to income. This means that as income rises, not only does the total tax amount increase, but so does the tax base—so the percentage tax rate rises. The tax office requires a minimum tax rate of 14%. The top tax rate in Germany is 42%. As income rises, the tax rate increases, for example, from an initial 14% to 20%. A special case applies to individuals with an annual income exceeding €250,731. In these cases, the wealth tax rate of 45% applies. The salary before taxes are deducted is referred to as the “gross salary.” After all taxes have been deducted, it is called the “net salary.” This distinction will play an important role in the following paragraphs.

What are the effects of a pay raise?

Now we come to the important part. What are the effects of a pay raise? The most obvious effect is that the employer pays a higher salary. This increases the gross income. Even small increases can result in seeing €100 more in gross salary on your pay stub at the end of the month. In the excitement of the pay raise, however, people often forget that a higher income has other implications as well. It’s important to consider your net income here. As previously explained, the amount of your income affects how much tax you pay. A pay raise therefore also affects your tax burden.

Cold Progression After a Pay Raise

You have likely realized by now that a pay raise can also lead to an increase in the taxes you owe. And it is precisely this process that is referred to as “cold progression.” It should be clear that the amount of tax owed always increases as income rises. With a constant tax rate, you would therefore not have the full salary increase at your disposal. Nevertheless, you have a little more money in your account at the end of the month.

However, the situation can also be different. Two factors must be considered. First, the rising tax rate (tax progression) must be taken into account. Added to this is general inflation. Inflation refers to the fact that goods and services tend to become steadily more expensive. With a salary that remains the same, purchasing power is thus reduced over a certain period of time. This means that after a certain time, you can buy less with the same salary.

Employers often account for inflation by offering a pay raise. However, in some cases, this only offsets inflation, which can lead to problems. This is because tax progression is often overlooked. With a higher income, you may be placed in a higher tax bracket. This increases your overall tax burden. As a result, depending on the amount of the pay raise, the combination of inflation and tax progression can lead to an overall reduction in purchasing power.

Example of Cold Progression

To make it easier to understand cold progression, let’s look at an example:

Tom is single and in tax bracket 1. As an employee, he earns 3,500 euros a month. Thanks to his good work, Tom is getting a three-percent pay raise, which amounts to 105 euros a month. However, on his next pay stub, only €74.40 of the raise remains as net income. How is that possible? With his new monthly income of €3,605, Tom must pay a higher tax rate. As a result of the pay raise, the tax rate increases from 25.3 percent to 25.8 percent. When inflation is factored in, this can lead to the tax burden growing at a faster rate than purchasing power.

Check for "cold progression" with a pay raise

Taxpayers should always weigh inflation and tax progression when considering a pay raise. To avoid mistakes and fully understand the tax implications, it makes sense to consult a tax advisor. During a consultation, the tax implications can be analyzed and explained. You can clarify any open questions directly. Normally, bracket creep will not result in a significant loss. More often than not, the combination of inflation and tax brackets simply erodes the increased salary.

Tax Consulting in Düsseldorf and Oberhausen

We hope this article was helpful and that you now understand what bracket creep means for taxpayers. As tax advisors in Düsseldorf and Oberhausen, we are your first point of contact for tax matters. Our team will answer your questions and assist with tax-related issues. Contact us to schedule a consultation at one of our offices.