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Since the 499th anniversary of Luther’s 95 Theses will be upon us, here is an explanation of how the sale of indulgences relate to the doctrine of penance (the following is a mere section from a longer discussion of the complex doctrine. This volume of Luther’s works has very useful notes. I am no Luther scholar, and I have these notes of great value in understand the context for Luther’s actions and writings):

Meanwhile the Sacrament of Penance had become an integral part of the Roman sacramental system, and had replaced the earlier penitential discipline as the means by which the Church granted Christians forgiveness for sins committed after baptism. The scholastic theologians had busied themselves with the theory of this Sacrament. They distinguished between its “material,” its “form” and its “effect.” The “form” of the Sacrament was the absolution; its “effect,” the forgiveness of sins; its “material,” three acts of the penitent: “confession,” “contrition,” and “satisfaction.” “Confession” must be by word of mouth, and must include all the sins which the sinner could remember to have committed; “contrition” must be sincere sorrow of the heart, and must include the purpose henceforth to avoid sin; “satisfaction” must be made by works prescribed by the priest who heard confession. In the administration of the Sacrament, however, the absolution preceded “satisfaction” instead of following it, as it had done in the discipline of the early Church. To justify this apparent inconsistency, the Doctors further distinguished between the “guilt” and the “penalty” of sin….

It was at this point that the practice of indulgences united with the theory of the Sacrament of Penance. The indulgences had to do with the “satisfaction.” They might be “partial,” remitting only a portion of the penalties, measured by days or years of purgatory; or they might be “plenary,” remitting all penalties due in this world or the next. In theory, however, no indulgence could remit the guilt or the eternal penalty of sin,5 and the purchaser of an indulgence was not only expected to confess and be absolved, but he was also supposed to be corde contritus, i. e., “truly penitent.”A rigid insistence on the fulfilment of these conditions would have greatly restricted the value of the indulgences as a means of gain, for the right to hear confession and grant absolution belonged to the parish-priests. Consequently, it became the custom to endow the indulgence-venders with extraordinary powers. They were given the authority to hear confession and grant absolution wherever they might be, and to absolve even from the sins which were normally “reserved” for the absolution of the higher Church authorities….

Charles M. Jacobs, “A Disputation of Doctor Martin Luther on the Power and Efficacy of Indulgences (The Ninety-Five Theses) 1517,” in Works of Martin Luther with Introductions and Notes, vol. I (Philadelphia: A. J. Holman Company, 1915), 18–19.