Ifo Viewpoint No. 48: Hands off the Mileage Allowance!

Hans-Werner Sinn
Munich, 2 October 2003

In its search for additional tax revenue the German government is considering reducing the mileage or distance tax allowance for employees from 40 cents (36 cents for short distances) to only 15 cents. As a result about 3 billion euro would flow into the treasury. This measure is labelled and justified as a subsidy reduction.

A confusion of terms exists here since true subsidy reductions lead to a decrease in public expenses and not to an increase in its revenues as would come from a reduction of the mileage allowance. But that is secondary. Not semantics but economic logic is called for, and this by no means justifies a reduction or elimination of the mileage allowance.

It is true that lowering the allowance will reduce the distances commuters cover because many will no longer be prepared to take jobs far from their homes. This fact is clear but the interpretation is not. Some say that less traffic is better, others say that mobility is good. Who is right?

In a market economy the criterion for correct human behaviour, as a rule, is a situation without government influence, i.e. without an income tax. An income tax is neutral and distortion-free if its collection does not change the economic choices of the people.

Here’s an example. Assume that someone is offered a job where he would earn 5,000 euro a year more but would also entail 4,000 euro more in commuting costs. He would accept the job if there were no taxes. And in fact he should accept it because his choice would bring a social surplus of 1,000 euro in comparison to retaining his old job.

An efficient system of taxation that does not alter his decision allows a deduction of the actual commuter costs. It defines the additional taxable earnings as 5,000 euro in salary minus 4,000 euro in commuter costs, or 1,000 euro. If, let us say, half of this 1,000 euro is taxed away, the advantage of changing jobs is reduced but still present. Thus a job change would still take place. A surplus for society in the form of 1,000 euro which arises from the change of jobs can be shared by the employee and the state.

A system that does not allow a deduction of costs would change the employee's decision in comparison to the reference situation without taxes and is therefore inefficient. The net wage increase in such a system would be 2,500 euro. After deducting the gross commuting costs of 4,000 euro the employee would be losing 1,500 euro, although a social gain for the individual and the state of 1,000 euro would still have been possible. The employee would now be reluctant to change jobs and a possible gain of 1,000 euro for all participants would not be realised.

These considerations are not limited to commuter costs alone but touch on the basic economic principles of taxation. Whenever a tax allows more or less than the deduction of the actual costs, it leads to a detrimental distortion of choices. For precisely this reason we have income and profit taxes that allow for the deduction of income-related expenses. If the principle of tax deductions for actual income-related expenses is abandoned, sand is thrown into the gears of the economy. If certain expenses are declared non-deductible, they appear much larger in an individual’s calculations than they really are, and this provokes economically incorrect decisions.

In order to justify the reduction of the mileage allowance it would be necessary to argue that this allowance is larger than the actual commuter expenses. However, at only 36 or 40 cents per kilometre, this is hardly possible. The estimations of the German Automobile Association (ADAC) on the mere monetary costs of driving lie in the range of 50 cents or more.

The non-deductibility of commuting costs acts like the imposition of a specific tax on such costs. A possible argument to justify such a tax is the cost of environmental pollution, congestion or road construction. But such costs provide weak arguments since the tax on mineral oil and the new German GPS road toll system are much more precise instruments for allocating these costs. Therefore: Hands off the mileage allowance!

Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute

Published as "Hände weg von der Entfernungs-Pauschale!", Süddeutsche Zeitung, No. 221, September 25, 2003, p. 20.