History

The history of the German Church tax system began in the 19th century (and not in 1933 as in Martin's answer).

In medieval times there was a complicated system of feudal levies to local aristocrats and Church instances. This were tithes and other taxes on (agricultural) real estate. With the reformation and later with the secularization ~1806 much of the Church's (Protestant and Catholic) property was expropriated and went to the state. But the state (monarch) felt a responsibility for the needs of the Church as an integral part of society and financed a mininmal Church live, if the remaining property did not suffice.

During the 19th century there was much migration within Germany. So there were Catholic parishes established in former Protestant areas and the other way around. Because of the growth of population there were also a rise of the need of the Church in old Catholic or Protestant areas. The state fulfilled this needs. But it wanted to save money and the idea of separation of Church and state gained ground. The solution for the state, but against the will of the Church, was: Church taxes.

In the end of the 19th century the states enacted laws giving the parishes the power but also the obligation to tax their parishoners. Now the state was able to reject each new petition for money from the Churches with: You have a possibility for getting money yourself.

When the after World War I the monarchy in Germany ended the separation of Church and state became law. (Before that the Protestant Churches still were [partly] incorporated in the state.) But the state did not want to let the Churches collapse because of that. So two decisions were made (that was the compromise in the National Assembly of the Reich): The old grants by the states to the Churches should be continued temporarily until some consolidation took place and there is an agreement how to end them (with which compensation). The Church tax system should be preserved. This was codified in article 138 I and article 137 VI of the Weimar Constitution of 1919.

As Martin Rosenau correctly mentions this was also guaranteed in the Reichskonkordat, the contract between the Pope and the German Empire concluded 1933 shortly after the Nazis came to power. But this was only the guarantee of an already established systen.

After World War II when todays constitution (Grundgesetz) was draftet there was no political majority for a different relationship to the Churches. So in article 140 Grundgesetz articles 136-139, 141 of the Weimar Constitution were incorporated in the Grundgesetz. The decisions of 1919 are valid till today. BTW: The temporary continuation of grants is still in force as no one had an interest to change this; there are current political campaigns for an end of the grants.

At some point between the 1900 and today the right to collect taxes passed from the parishes to dioceses. Today the state collects the Church tax with the income tax and transfer it (minus a collection fee) to the dioceses. The dioceses pay the priests, other pastoral employees and administrative staff and give money to the parishes for local projects. For today's praxis see also Codosaur's good answer.

Canon law

The relevant parts of the CIC are:

Can. 222 §1. The Christian faithful are obliged to assist with the needs of the Church so that the Church has what is necessary for divine worship, for the works of the apostolate and of charity, and for the decent support of ministers.

The faithful in Germany fulfill this obligation through the Church tax. In other countries you have to make donations - formally voluntary but bound by this canon.

Can. 1263 After the diocesan bishop has heard the finance council and the presbyteral council, he has the right to impose a moderate tax for the needs of the diocese upon public juridic persons subject to his governance; this tax is to be proportionate to their income. He is permitted only to impose an extraordinary and moderate exaction upon other physical and juridic persons in case of grave necessity and under the same conditions, without prejudice to particular laws and customs which attribute greater rights to him.

The last half sentence is a so called "clausula teutonica", a norm specific for the German (and Austrian, Siwss) situation. So the German Church tax was secured when the CIC was reformed in 1983. The particular canon laws on the Church tax are diocesan laws, but coordinated between the dioceses.

In context of the Church tax system it is possible for a German Catholic to renounce his membership towards a state authority (Kirchenaustritt). After that he has not to pay any Church tax any longer. The Church sees this act not only as a refusal of the tax, but as an exit out of the Church. For most aspects these people are not considered Catholics any longer. Of course the baptism cannot be lost, but the sacraments are denied and a Catholic burial is not possible.

After some discussion on what the legal basis for this praxis is, there was a General Decree of the German Bishops Conference with Roman recognition, establishing the consequences of a Kirchenaustritt. The denial of the sacraments and - normally - no Catholic burial belongs to them.

Discussions

There are critics on that system mainly from three sides:

• Peolpe who want to stay Catholic, but don't want to pay Church tax, e.g. because they do not trust their bishop to do good with that money. Often it is stated: I will give the same amount of money to my local parish.
• Some people inside Church hope that a poor Church will be "better", more authentic, more following the gospel. The abolition of Church tax may have a positive impact on the Church.
• From outside of the Church there is criticism on the collection of the Church tax by the state. Some political parties call for further separation of Church and state.

But most people renouncing their membership of the Catholic Church really want to leave the Church, e.g. because of the lost of faith or (recently) anger about the dealing with sexual abuse.

I draftet this answer based on my knowledge out of many readings over the years. I can add sources for specific aspects, if someone asks.

Whose idea was this ...

This is one leftover of a contract signed in 1933:

The Nazi government made the Churches some offers (that tax is only one of them) if the Churches agree not to query the laws of the state.

Not knowing that the reason for this was that the government was planning the assassination of millions of people and it wanted the Churches not to take any actions against this, the Churches accepted the offer.

... and how does it square with canon law?

According to canon law, you have to support the Church with money. In Germany and Austria, it is assumed that you observe this rule if you pay the tax. (This means: If you don't declare renouncing your membership at the tax office.)

Is there still a collection taken at Mass in Germany?

Yes.

However, most faithful only donate a symbolic amount of money (much less than the tax) or even nothing.

Does it drive people away from the Church ...

Definitely yes, but ...

... by giving them a financial incentive to leave the faith ...

... this has nothing to do with faith:

According to some study ten years ago, only 15% of the Catholics attend the Mass on Sundays. (From my personal observations, I think the percentage in 2021 is even much less.)

And what about the remaining 85%?

Some of them are faithful not attending the Mass on every Sunday, but the large majority are people who are officially baptized but not believing in God at all. Often even publicly claiming that religion is hoax.

Such people declare renouncing their membership.

The financial aspect is only the occasion but not the real reason for doing this.

The question as posed gives a distorted impression of what the "Kirchensteuer" actually can and cannot do. This is the information from one of the largest German Tax consultancy companies (WWKN) in English:

In Germany, on the basis of tax regulations passed by the communities and within the limits set by state laws, communities may either

• require the taxation authorities of the state to collect the fees from the members on the basis of income tax assessment (then, the authorities withhold a collection fee), or
• choose to collect the church tax themselves.

In the first case, membership in the community is entered onto a tax document (Lohnsteuerkarte) which employees must surrender to their employers for the purpose of withholding tax on paid income. If membership in a tax-collecting religious community is entered on the document, the employer must withhold church tax prepayments from the income of the employee in addition to other tax prepayments. In connection with the final annual income tax assessment, the state revenue authorities also finally assess the church tax owed. In the case of self-employed persons or of unemployed taxpayers, state revenue authorities collect prepayments on the church tax together with prepayments on the income tax.

If, however, religious communities choose to collect church tax themselves, they may demand that the tax authorities reveal taxation data of their members to calculate the contributions and prepayments owed. In particular, some smaller communities (e.g. the Jewish Community of Berlin) choose to collect taxes themselves to save collection fees the government would charge otherwise.

The church tax is only paid by members of the respective church. People who are not members of a church tax-collecting denomination do not have to pay it. Members of a religious community under public law may formally declare their wish to leave the community to state (not religious) authorities. With such a declaration, the obligation to pay church taxes ends. Some communities refuse to administer marriages and burials of (former) members who had declared to leave it.

Taxpayers, whether Roman Catholic, Protestant or members of other tax-collecting communities, pay between 8 percent (in Bavaria and Baden-Wuerrttemberg) and 9 percent (in the rest of the country) of their income tax to the church or other community to which they belong.

So the law explicitly says churches may tax their members, it is not an obligation from the state. Therefore, whether or not it has a negative effect on church membership and how to react on this is entirely in the hands of the clergy. This being said, the majority of churches in all regions of Germany tax their members. About 70% of church revenues come from church tax (Kirchensteuer) in Germany. This was about 9.2 billion euro in 2010.

These religious communities collect a church tax in Germany:

• The Evangelical Church (Evangelische Kirche)
• The Roman Catholic Church (Römisch-katholische Kirche)
• The Jewish Community (Jüdische Gemeinde)
• The Old Catholic Church (Altkatholische Kirche)
• Various Free Religious communities (Freireligiöse Gemeinden)

As to the origins: giving a share of one’s income to the church has been a part of European tradition for centuries. Today, several countries continue to collect a “church tax” on behalf of officially recognized religious organizations, in some cases levying the tax on all registered members.1 These payments add up to billions of euros annually and represent the biggest source of revenue for many religious institutions.

Contrary to @Zippy2006's comment: in 2012, the Catholic church officially announced they will refuse sacraments and rituals for those that leave the church, which is the only way to stop paying the Kirchensteuer. Archbishop Robert Zollitsch, the president of the German bishops' conference, said that not paying taxes for the church is a grave offense, and that sacraments will be banned for those who distance themselves from the church. Many Germans have considered this decree a threat of excommunication.

According to Pew Research, growing numbers of people have been opting out of the tax by formally deregistering from their churches, perhaps another sign of secularization in the region. Some European advocates for greater distance between church and state argue that church tax systems violate freedom of religion and have called for their abolition. The Church tax law is under scrutiny from the EU for this reason, as it allows for the taxation of immigrants who were baptized in their country of origin but register as atheist in Germany.

Germany is not the only country in Europe that has a Church Tax law. It's also not the country with the highest rates of people stopping to pay the tax:

The church tax is however not the main driver behind the fall in European religiosity, as this graph from Pew research indicates, comparing religiosity and attendance in European countries with and without a state church tax: