German Federal States Require Greater Tax Autonomy

If German Minister of Finance, Wolfgang Schäuble, should happen to be stuck for ideas as to what to give his state ministers for Christmas, he need only read the states' proposal for reform of the German Federal Financial Equalisation System (Finanzausgleich). According to the proposal, federal states should receive nine billion euros in tax receipts per year from the federal government. This being the case, the joyful tidings, announced by the Mayor of Hamburg Olaf Scholz, might come true: "The weaker states will become closer to the average, the strong states, however, will be able to hold onto more of their money than before."

What is this reform about, aside from the federal government showering German states with Christmas gifts? The function of the Federal Financial Equalisation System is to equip the federal government, states and municipalities in Germany with adequate financial resources. Up to now, the Financial Equalisation System has functioned on four levels. The first level consists in distributing revenues from the collection of VAT, income tax and corporate tax contributions amongst the federal government, states and municipalities. On the second level, states distribute the received tax revenue amongst themselves. Three quarters of VAT revenues are thereby distributed on the basis of states' population figures, the remainder is allocated on the basis of the states' financial resources. The third level is the horizontal Financial Equalisation System. This consists in redistributing tax incomes from financially strong states to financially weak states. The fourth and final level consists in the allocation of additional resources from the federal government to certain states, to compensate, for example, the "high costs of political leadership" in small states. In 2019, the existing regulations will become void, meaning that a new Financial Equalisation System must be settled on.

The most significant change in the reform proposed by the federal states is that the third level of the system is to be omitted. Instead, the redistribution of tax revenues from VAT should take place as part of the second level. This would be of benefit to financially weak states, who would then receive more money. What is one to make of this?

The German Federal Financial Equalisation System is in dire need of reform. First of all, the system lacks transparency. Secondly, it undermines any incentives for states to pursue an increase in their taxable capacity. A third issue is that the system robs states of tax autonomy. States are able, for example, to determine the level of expenditures, but it is only the land transfer tax for which they are able to increase or decrease revenues by adjusting tax rates themselves. Finally, the federal government and German states are jointly liable for their debts; decisions about fiscal policy, however, are made independently. This doesn't match up.

The reforms proposed by the states do not solve a single one of these problems. The complexity of the Federal Equalisation System would of course be improved by the omission of the third level, but the transparency of the system would be further improved if redistribution of VAT revenues was instead fully shifted to the third level. It seems that the exact opposite will happen. The distribution of revenues from VAT shall now depend to a greater extent on the states' financial strength. In addition, financially strong states will no longer make payments to financially weak states. Given that VAT cannot be as clearly attributed to single states as direct tax can, redistribution amongst individual states will be less transparent.

It will also become more difficult for states such as Bavaria and Baden-Württemberg to publicly assert their status as the federal states which make the largest net payments in the Financial Equalisation System. They shall thereby lose the political trump card, which this previously gave them. The reforms should have achieved a lot more; giving greater tax autonomy to individual federal states for example. Regardless of whether the federal government allocates the billions hoped for, the existing plans for reform of the Financial Equalisation System are disappointing, for citizens and for tax payers.