ZEW Study on the German Fiscal Equalisation Scheme - A Reform Package for Sustainable Federalism in Germany

The upcoming revision of the Fiscal Equalisation Law (act on redistribution of income between the German Federal States) provides a historic opportunity. A reform package that addresses the issue of excessive legacy debt, missing tax autonomy for the federal states, and simplifications to the fiscal equalisation scheme would make German federalism sustainable. This is the result of a study conducted by ZEW on behalf of the Konvent für Deutschland, an independent cross-party group of policy advisors.

"An independent right of the federal states to set taxes would mean more democracy," Friedrich Heinemann says. Heinemann is head of the Research Department “Corporate Taxation and Public Finance” at ZEW and author of the study.

The study recommends establishing "a federalism of responsibility" in Germany. According to Heinemann, time has come for state politicians to accept responsibility for taxes, in addition to government spending, in front of their electorate. Granting the federal states the right to impose surcharges or deductions on income tax payments would be the best way to achieve that. Concerns about the negative consequences of unlimited tax competition should be taken seriously, Heinemann adds. A level playing field has to be established before the competition begins, for example by reducing the burden caused by excessive legacy debt. Moreover, surcharges and deductions should be limited within a fixed range during the early reform stages.

Other elements of the fiscal equalisation scheme should be reviewed and remodelled as well, according to ZEW researchers. A major step towards simplifying the scheme would be to completely transform the non-transparent, multilevel equalisation system into a "vertical model", in which the federal government allocates financial resources to the federal states. The current horizontal fiscal equalisation scheme between the federal states could then be replaced. "When introducing these reforms, the protection of distributive outcomes under the status quo should be a major concern," Friedrich Heinemann emphasizes. On no account should the reform entail fundamental changes to the distribution achieved under the current equalisation system, i.e. net recipients should not suddenly be left empty-handed. Otherwise, the chances to establish models like this would be nil, according to Heinemann.

It comes as little surprise that the current debate on reforming federalism lacks ambition, ZEW researchers say, compared to these far-reaching ideas. Today, state politicians are in a convenient position: responsibility for the income tax rate is not lying with them. This reluctance to reform, however, seriously threatens the future of the federal system. The federal states are increasingly dependent on government transfers and have no autonomy concerning the revenue side of state budgets. This is the de facto end of federalism in its fiscal policy dimension, the authors of the study conclude.

The ZEW study "Reformoptionen für einen Verantwortungsföderalismus" (Reform Options for a Federalism of Responsibility) was presented in Berlin on 1 December by the Konvent für Deutschland under the chairmanship of former President of Germany Roman Herzog.

For more information please contact

Dr. Friedrich Heinemann, Phone +49 621/1235-149, E-mail heinemann@zew.de