Compromise on the Financial Equalisation Scheme – A Dark Day for German Federalism

The German government and the state parliaments have adopted a resolution which foresees a revision of the Federal Financial Equalisation System. The new legislative framework will see the end of the "horizontal" model, which consists in redistributing tax revenues from financially strong states to financially weak states. Instead, the financial strength of the states will be largely offset at an earlier stage, namely by an initial distribution of value-added tax (VAT) revenues among the federal states. Professor Friedrich Heinemann, head of the ZEW Research Department "Corporate Taxation and Public Finance" at the Centre for European Economic Research (ZEW), takes a critical stance on the reform.

The new system aims to ease the current tensions between contributors and recipients by a vertical distribution of VAT revenues and higher government payments to the federal states. Professor Friedrich Heinemann explains, "None of the key problems of the equalisation system will be solved in this current system. Federal states continue to be financed from a common tax pool, a system that is impenetrable for the voters. This allows for states which refuse to improve their growth opportunities to wait for the helping hand of solidarity." Adopting a vertical distribution model, according to which payments are allocated by the central government, instead of a horizontal model, which consists of redistribution between states, will in no way reduce incentive problems. "This reform lacks courage and further damages German federalism." For the states, it is a politically convenient solution, since the federal government bears the costs and the Minister-Presidents do not have to assume tax responsibility," says Heinemann.

Decision-makers should on no account stop at this compromise. As a possible solution, Heinemann proposes a reform model developed at ZEW. In a study conducted on behalf of the "Konvent für Deutschland", an independent cross-party group of policy advisers, ZEW developed a model for "responsible federalism". By establishing this model, federal states would have the possibility to impose surcharges and grant deductions on income taxes to a certain extent. This would truly be a breakthrough for fiscal responsibility: "If states had more fiscal autonomy, voters would no longer uncritically demand higher expenditures in state elections, but also ask for ways of reciprocal financing."

Despite the fact that the granting of additional federal money marks a success in negotiations for the federal states, this compromise is by no means a victory but a dark day for German federalism, according to Heinemann. "When the debt brake enters into force in 2020, the states will entirely depend on tax incomes, over which they have no control. From a fiscal point of view, the states are currently in the process of abolishing federalism."

For more information please contact:

Prof. Dr. Friedrich Heinemann, Phone +49(0)621/1235-150, E-mail heinemann@zew.de