7. Regional spending, tax autonomy and equalization
7.2. Germany
the word. The third form of equalization could be interpreted as a cantonal grant for federally regulated social security programmes. Horizontal equal- ization only occurs indirectly as regions which contributed less into the scheme may also stand to benefit more in terms of above-average social security receipts.
ignored these constraints and expected federal supplementary grants as a bailout relief instead. Third, regional banks (Landesbanken) often maintain close links with leading regional politicians who have been willing to grant cheap credit. Under pressure from the EU, this strategy is now changing.
Banks are being privatized and must open themselves up to foreign creditors.
As a result, they must improve their international credit ratings and display considerable credit market discipline (Rodden 2003: 175–8). Finally, the shared tax system itself is often put forward as the main reason for regional budgetary indiscipline. Shared taxes are said to blur accountability: they do not reward regions that have a smart fiscal and budgetary policy and they do not punish regions which perform poorly on both accounts.
Shared taxes may not be conducive to efficiency or accountability. Yet their widespread presence has facilitated the achievement of certain redis- tributive goals. Indeed, no other federal state in Western Europe puts such a strong emphasis on territorial equalization than Germany. The fiscal equal- ization process takes on massive proportions, more so after the relatively poor eastern regions have been fully integrated into the equalization scheme. In 1999, equalization payments made up roughly €27 billion.
German unification has not drastically changed the ambitions of the fiscal equalization process. The federal constitution prescribes a ‘uniformity of living conditions’ throughout the federation. This requirement was only mildly relaxed after unification; until 1994, it was known as a ‘unity of living conditions’. Germany is also the only one of our case studies which combines both forms of horizontal equalization (broadly and narrowly defined). In 1999, almost three-quarters of the equalization payments came under the form of federal equalization payments; the remaining quarter of the payments came as horizontal equalization payments, narrowly defined.
Vertical fiscal imbalances are reduced by distributing shared tax revenues first. The constitution stipulates the size of the regional pie for personal income and corporate taxes. Half of the corporate tax revenues accrue to the regions, the other half remain in federal hands. Fifteen per cent of personal income-tax revenues flow to the municipalities; the remaining 85 per cent are equally divided between the centre and the regions. The derivation prin- ciple is followed for the distribution of both taxes (the place of residence of a person or a firm counts as the criterion). In contrast, the distribution of VAT, the third major shared tax resource, is stipulated in a federal law. This law is periodically adjusted (for which a federal bicameral majority is needed) and is the flexible element of Germany’s shared tax system. As it stands, 2.2 per cent of VAT revenues accrue to the municipalities (a compen- sation for recently abolishing a local tax on ownership of corporations) and 5.6 per cent is set aside for improving the federal government’s pension plan. The remaining 92.2 per cent is divided between the federal and regional governments, respectively on a 50.25–49.75 percentage basis (Quebec Commission 2001: 6). VAT receipts constitute the largest federal
revenue resource (58.0 per cent) followed by personal (36.4 per cent) and corporate income tax revenues (5.6 per cent). For the regional and local gov- ernments, personal income tax and VAT receipts are almost equally impor- tant. They make up respectively 43.0 and 40.0 per cent of all regional and local revenues. Corporate income taxes come third, filling close to 7.0 per cent of the regional and local revenue coffers.
VAT is not only the flexible component of Germany’s shared tax system; it is also the component that is explicitly used for equalization purposes.
Seventy-five per cent of regional VAT revenues are distributed on a per capita basis (and not on an origin basis). Consequently, regions with below average per capita VAT contributions benefit from the redistribution of VAT accord- ingly. The distribution of the remaining 25 per cent takes specific horizontal equalization purposes into account. To that purpose, the tax capacity (Steuerkraft) of each region is calculated by considering the average personal income of its working population and its corporation and regional tax receipts. The regional share of VAT revenues is distributed in such a way that the average tax capacity of the poorest regions rises to at least 92 per cent of the federation-wide average. In 1999, 7 out of 16 regions benefited from this arrangement (Jeffery 2003: 25).
Following the redistribution of regional VAT, affluent regions engage in a form of horizontal equalization (in the narrow sense). Instead of using aver- age regional tax capacity as a benchmark, a new measure is calculated (Finanzkraftor ‘fiscal capacity’). This measure takes average receipts of per- sonal and corporate income and value added taxes into account in addition to certain socio-economic or demographic criteria. For instance, does the region have a high urban density (city states), does it contain important sea- ports etc.? As part of this process, the city states of Berlin, Hamburg and Bremen see their real population figures inflated by 35 per cent. Although such a measure could be justified on the basis of cost-intensive services which city regions provide to citizens who live in adjacent regions, the same argument cannot be used to motivate criteria which lead to the ‘preferential treatment’ of certain regions. As Charlie Jeffery points out, no clear ratio- nale, other than logrolling in a federal package deal on fiscal equalization reform (requiring the consent of the regions in the Bundesrat), can justify both adjustments (Jeffery 2003). As a result of the horizontal equalization process (narrowly construed) the average fiscal capacity of the poorest regions increases further to 95 per cent of the national average. The higher the regional fiscal capacity rises above the average regional capacity, the higher the regional contributions to equalization. This principle is heavily criticized because regions with a regional fiscal capacity that is 10 per cent higher than the federation-wide average must set aside 80 per cent of their marginal revenues for equalization purposes.
As if the horizontal equalization (narrowly defined) were not enough, in the final stage of the equalization process, the federal government
contributes to additional horizontal equalization by means of so-called federal supplementary allocations. These allocations should guarantee that the regional capacity of the poorest regions is elevated further to 99.5 per cent of the federation-wide average. In addition, more supplemen- tary allocations are set aside to remediate specific administrative, infrastruc- tural (cf. the newly acceded Eastern regions) or budgetary (cf. the precarious budgetary position of Bremen and Saarland) problems of certain regions (Jeffery 2003: 26–7).
The German fiscal equalization process has been widely criticized for its complexity, arbitrariness and excessiveness. The complexity speaks for itself;
the arbitrariness is exemplified by the rationale for certain payments.
Equalization payments are excessive because some regions at the receiving end may be better off in terms of their per capita fiscal capacity after the fiscal equalization process than some of the donor regions at the start of this process. Equalization is particularly harmful for Baden-Württemberg, North- Rhine Westphalia and Bavaria. These are regions which, apart from being among the most affluent, are among the most densely populated as well.
The average fiscal capacity of these regions even drops to the three bottom positions at the end of the equalization process (Sturm 2001). Admittedly, fiscal capacity does not take expenditure needs into account: average per capita expenditures are much higher in the Eastern regions because of higher unemployment figures there. However, one may wonder what incentives the affluent regions are left with to maximize their own revenues, or what stim- uli the poor regions are given to organize their expenditures in a more cost-efficient way?
Given these criticisms, the German Constitutional Court has played an increasingly important role in addressing the complaints of some of the top
‘payee’ and even some of the ‘receiving’ regions (Bremen and Saarland) (Mackenstein and Jeffery 1999). Such complaints first emerged in the 1980s, but they could be held off in the first few years after unification. The Eastern regions were kept out of the equalization scheme until January 1995 and the federal government turned into the main paymaster of increased equaliza- tion payments.
However, halfway through 1998, Baden-Württemberg and Bavaria, later to be joined by Hesse, presented a new complaint to the federal Constitutional Court. As payee regions, they addressed the excessive character of equaliza- tion payments as well as the arbitrariness of several of the special payments made. In its judgement, delivered in November 1999, the Court forced the regions and federal government into working out a more transparent equal- ization scheme by 2005. This scheme had to leave the basic principle of equalization intact and had to retain a number of specific regional payments (though they should be better justified).
The federal government, with the consent of the Bundesrat, succeeded in working out such an alternative scheme. However, the changes, which
entered into force on the last day of 2004, are at best incremental. The share which contributing regions should set aside for equalization purposes is somewhat reduced (72.5 instead of 80 per cent of marginal revenues above 110 per cent of the national average). Furthermore, 12.5 per cent of tax surplus revenues in comparison with the previous year should not be used for equalization purposes (Gunlicks 2002; Ziblatt 2002). The changes also abolish or reform some of the arbitrary special payments. The federal government also upholds a strong commitment to pay infrastructure assistance to the Eastern regions and maintains a solidarity charge on income tax.
The legislative compromise (as well as a preceding deal on federal tax reform) still required considerable side payments. Some regions would otherwise have refused their consent in the Bundesrat (see Chapter 6). Most importantly, the agreement did not substantially alter the level of regional tax autonomy or reduced the overall tax burden. In sum, the recent reforms have altered Germany’s architecture of fiscal federalism ‘at the margins’
only. Although the new arrangements are meant to last until 2019, it may not take long before the compromise is being challenged in the Constitutional Court again.