90       UMAR      IB revija  1-2/2006
1. Introduction
The simplification of the tax system is a key
objective of many income tax reform proposals.
This is not only because complexity leads to high
compliance costs for taxpayers. The complexity of
the income tax system is also seen as an obstacle
to fairness and efficiency. For instance, complexity
is thought to be an obstacle to achieving a fair
distribution of the tax burden because it might
allow taxpayers with high incomes to use tax
loopholes and reduce their tax burden.
The present paper quantifies the impact of tax
simplification in combination with a flat tax rate
on the distribution of after tax income and the
marginal income tax rates faced by different types
of taxpayers. The change in marginal income tax
rates is of interest because marginal tax rates may
be considered as rough indicators for the
distortions caused by the tax system. Our analysis
is based on our simulation model for the German
tax and transfer system (FiFoSiM) using income
tax microdata and household survey data.1
We model tax simplification as the abolition of a
set of deductions from the tax base included in
the German income tax system. If these measures
are combined with a reduction of income tax rates
to preserve revenue neutrality, the distributional
impact depends on the type of rate schedule
adjustment. We also consider the effect of these
tax measures on the marginal income tax rate.
In the literature, quantitative studies of the impact
of tax simplification on the efficiency of the tax
system and the distribution of income exist only
for the U.S. In a recent contribution, Gale and
Rohaly (2003)2 study the effect of different tax
simplification proposals. Among other things, they
consider the introduction of a f lat rate income
tax, combined with a value added tax reform. They
find that such a tax reform would increase the tax
burden of the middle class and reduce the tax
burden for very high and very low incomes. Gale
et al. (1996)3 analyse the effects of introducing a
flat tax in the US according to the concept of Hall
and Rabushka (1995)4 and similar versions. They
conclude that high income households profit most
while households with low incomes suffer from a
flat tax reform.
The set-up of the paper is organised as follows:
chapter 2 contains a short description of FiFoSiM,
chapter 3 presents the tax simplification scenarios.
Chapter 4 illustrates the effects on distribution.
Chapter 5 presents the effects on the marginal tax
rates as a measure for efficiency, before chapter 6
summarises and concludes this paper.
2. FiFoSiM: Database and Model
Our analysis is based on a microsimulation model
for the German tax and transfer system (FiFoSiM)
using income tax and household survey microdata.
The approach of FiFoSiM is innovative in so far
Andreas Peichl*
The Distributional Effects of a Flat Tax Reform in
Germany - a Microsimulation Analysis
* Center for Public Economics, University of Cologne, Albertus-Magnus-Platz, 50923 Cologne, Germany. E-Mail: a.peichl@uni-
koeln.de, www.fifo-koeln.de.
  This paper is a summary of my presentation held at the CEF - International Academic Forum on Flat-Tax-Rate on February 3rd
2006. A more detailed analysis of the economic effects of tax simplification in combination with tax rate schedule reforms
can be found in: Fuest, C., Peichl, A. and T. Schaefer (2006), Does Tax Simplification yield more Equity and Efficiency? An
empirical analysis for Germany. University of Cologne, Working Paper.
1 The model is described in: Fuest, C., Peichl, A. and T. Schaefer (2005): Dokumentation FiFoSiM: Integriertes Steuer-Transfer-
Mikrosimulations- und CGE-Modell, Finanzwissenschaftliche Diskussionsbeiträge Nr. 05 – 03. A specific feature of FiFoSiM
is the use of a dual database of FAST- and SOEP-data.
2 Gale, W. and Rohaly, J. (2003). Effects of Tax Simplification Options on Equity, Efficiency, and Simplicity: A Quantitative
Analysis.
3 Gale, W. G., Houser, S. and Scholz, J. K. (1996). Distributional Effects of Fundamental Tax Reform, in H. J. Aaron and W.
G. Gale (eds), Economic Effects of Fundamental Tax Reform, The Brookings Institution, Washington, D. C., pp. 281.320.
4 Hall, R. E. and Rabushka, A. (1995). The Flat Tax, 2nd edn, Hoover Institution Press, Stanford.
IB revija 1-2/2006       UMAR       91
5 We use the so called “new OECD-scale” which weights the household head with a factor of 1, household members over the age
of 15 with 0.5, and under 15 with 0.3. The households net income is divided by the sum of the individual weights of each
member (=equivalence factor) to compute the equivalence weighted household income.
6 The measurement of polarisation was introduced by Wolfson, M. C. (1994). When Inequalities Diverge, American Economic
Review 84(2): 353-358, and Esteban, J. and Ray, D. (1994). On the Measurement of Polarization, Econometrica 62(4): 819-
851, to analyse the phenomenon of the „declining middle class” in the United States which could not be satisfactorily
explained by standard inequality measures (see Schmidt, A. (2004). Statistische Messung der Einkommenspolarisation, Eul-
Verlag, Lohmar. for a survey). The distinction between inequality and polarisation can be vividly explained using the
extremes: minimal inequality and minimal polarization is given by a uniform distribution of income. Maximal inequality is
given if N-1 people realize a zero income and the remaining person receives the whole income. Polarisation is maximal if
there are two (almost identically large) groups which are very heterogeneous regarding their incomes (heterogeneity between
groups) but very homogeneous inside each group (homogeneity within groups).
7 Schmidt (2004) creates a polarisation index which in analogy to the gini index (lorenz curve) is based on a polarisation curve
for a better comparability of the results and their interpretations.
€
as it creates a dual database using two microdata
sets for Germany: FAST98 and GSOEP. FAST98
is the income tax scientific use-file 1998 (FAST
98) containing a 10%-sample of the German federal
income tax statistics. FAST98 includes the relevant
data from income tax files of nearly 3 million
households in Germany. Our second data source,
the German Socio-Economic Panel (GSOEP), is
a representative panel study of private households
in Germany. In 2003 GSOEP consists of more
than 12,000 households with more than 30,000
individuals. A specific feature of FiFoSiM is the
simultaneous use of both databases allowing for
the imputation of missing values or variables in
the other dataset.
The layout of FiFoSiM follows several steps: First
the database is updated using the static ageing
technique which allows controlling for changes in
global structural variables and a differentiated
adjustment for different income components of the
households. Second, we simulate the current tax
system in 2006 as the benchmark for different reform
scenarios which are computed in the third step.
The modelling of the tax and transfer system uses
the technique of microsimulation. FiFoSiM
computes individual tax payments for each case in
the sample considering gross incomes and
deductions. The individual results are multiplied
by the individual sample weights to extrapolate the
fiscal effects of the reform with respect to the whole
population. A detailed description of the FiFoSiM
model can be found in Fuest et. al (2005).
3. Tax Simplification Scenarios
The basic steps for the calculation of the personal
income tax under German tax law are as follows.
The first step is to determine the income of a
taxpayer from different sources and to allocate it
to the seven forms of income defined in the
German income tax law. For each type of income,
the tax law allows for certain income related
expenses. The second step is to sum up these
incomes. Third, deductions like contributions to
pension plans or charitable donations are taken
into account, which gives taxable income as a result.
Finally, the income tax is calculated by applying
the tax rate schedule to taxable income.
Tax base simplification is modelled as the abolition
of a set of specific deductions from the tax base
included in the German income tax system. Our
choice of simplification measures is inf luenced
by the German policy debate about existing tax
breaks and deductions. Naturally, the analysis is
restricted by the availability of data. The effects of
various tax simplification scenarios are calculated
in the microsimulation model FiFoSiM. Tax
simplification in terms of tax break abolition
generates additional revenue. As we intend to
design a potential tax reform without revenue
effects, we model a flat tax rate of 30% and a basic
tax allowance of 9500    .
4. Distributional Effects
To analyse the distributional effects of different
reform scenarios we compute different
distributional measures based on equivalence
weighted household net incomes.5 Furthermore,
as an innovative element of our analysis, we
estimate the polarisation effects of each alternative.
Distributional measures have been widely used in
simulation studies, whereas polarisation measures
have been seldom respectively never used in
microsimulations (for Germany).6 Generally
speaking, polarisation is the occurrence of two
antipodes. A rising income polarisation describes
the phenomenon of a declining middle class
resulting in an increasing gap between rich and
poor. The proportion of middle income households
is declining while the shares of the poor and the
rich are both rising. As a distributional measure
we compute the Gini-Index and the measure of
Schmidt (2004)7 as a polarisation index.
92       UMAR      IB revija  1-2/2006
The main results are presented in table 1. We
simulate the percentage changes of the mean
income in each decile and the distributional and
polarization measures compared to the status-quo
for each tax rate schedule adjustment, the
simplification bundle (kumAB) and the combina-
tions of rate schedule reforms and tax base simplifi-
cation.
The first column of table 1 shows the cumulated
effects of the simplification bundle. The accumu-
lated measures of tax simplification burden the
higher incomes more heavily than the middle and
the lower incomes. Inequality and polarisation are
both reduced.
The isolated effects of changes in the tax schedule
are as follows. The adjustment to the right of the
current schedule (E061) increases inequality as
well as polarisation. The f lat rate tax strongly
increases inequality while the polarisation index
decreases. The obvious winner of a flat tax rate is
the 10th decile due to lower marginal rates and to
some extent the first decile while the middle to
upper deciles suffer from an increased tax charge
due to the flat tax reform. These effects result in
an overall increase in the gini index.8
The revenue neutral combination of the tax base
simplification bundle with a tax schedule
adjustment to the right (kumAB1) decreases both
the inequality and the polarisation indices, whereas
the combination with a flat-tax (kumAB2) increa-
ses the inequality but reduces the polarisation.
Given these results, we can conclude that revenue
neutral tax simplification does not necessarily lead
to redistribution from poor to rich. The combina-
tion with the adjustment of the current tax schedule
even leads to a decrease of inequality, i.e. the
simplification of the tax system can lead to a more
equal distribution of after tax income. More
inequality only arises if tax base simplification is
combined with the introduction of a flat rate tax.
5. Tax Simplification and the
Efficiency of the Tax System
There are many ways in which the simplification
of the tax system affects its eff iciency. In this
section, we analyse the effect of tax simplification
on the marginal income tax rate faced by different
groups of taxpayers. The underlying idea is that
the marginal income tax rate affects the labour
supply and savings incentives. Here, we focus on
the marginal labour income tax rate. The results
are summarised in table 2.
It turns out that tax base simplification without
tax rate adjustments increases the marginal tax rate
8 The decrease in polarisation is surprising at first glance, but this result can be attributed to the following two effects: The
heterogeneity between the two groups decreases because of the higher tax burden for most people above the median income
and because of a decrease of the tax liability of some people below the median. The homogeneity within the upper group
decreases as well because of the opposite directions of the effects in those deciles. Both effects lead to a decrease in the
polarisation index.

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IB revija 1-2/2006       UMAR       93
for all taxpayers. This is not surprising, given the
progressive nature of the income tax schedule.
Combining these measures with a reduction of tax
rates over the entire income tax schedule
(kumAB1) reduces the marginal tax rate for almost
all taxpayers with the exception of the highest
income decile. The combination with a f lat rate
tax (kumAB2), in contrast, reduces the marginal
tax rate considerably (by five percentage points)
for the highest income decile. For the middle
income deciles, the marginal tax rate increases,
especially for the third and the fourth income
decile. This suggests that the efficiency gains that
can be achieved through tax simplification,
combined with the introduction of a flat rate tax,
are limited. This is mainly due to the fact that
revenue neutrality requires a f lat tax rate of 30%.
If the broadening of the tax base goes beyond the
measures considered here, revenue neutrality can
be achieved at a lower statutory tax rate. In this
case, the reduction of the marginal tax rate will
also be lower.
6. Summary and Conclusion
In this paper, we have examined the effects of tax
simplification on the income distribution and
marginal income tax rates. Our results suggest that
f lat tax reforms combining tax base broadening
with a single tax rate can increase inequality at the
expense of the upper middle class. This might be
the reason for the dispute about the political
implementation of a f lat tax reform despite the
incontestable advantages of a flat tax rate regarding
tax administration. Thus it might be advisable to
separate the tax simplification objective from tax
rate schedule issues.
Finally, income distribution is only one relevant
aspect of tax reforms. If a higher national income,
more efficiency or better incentives can be achieved
through an income tax reform, higher inequality
of income distribution might be deemed accepta-
ble.
Whether tax simplification leads to more fairness
in terms of higher after-tax income equality depends
on the simplification method. The tax base
simplification package considered here, combined
with an adjusted direct progressive tax rate reduces
the inequality of income distribution maintaining
revenue neutrality. In this regard, more fairness
through tax simplification is possible.

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