10 Germany

Teresa Ter-Minassian
Published Date:
September 1997
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Paul Bernd Spahn and Wolfgang FÖttinger

A cursory analysis of intergovernmental arrangements in Germany points to many features that characterize unitary states: a strong central government with an extensive area of influence, uniformity in legislation on almost all important issues, and a uniform tax system. For the provision of public goods, the German Constitution emphasizes uniformity of living conditions for the whole nation (rather than minimum standards). A further characteristic of German federalism is the strong coordination of policies among different layers of government. To be sure, other elements of the arrangements vindicate the official title of federation: the existence of intermediate levels of governments, 16 Länder (or states), and a local government sector the importance of which cannot be overemphasized. Nevertheless, the impression of a “unitary German federation” remains strong.

Structure of Government

The Constitution of 1949 confers primary state powers to the states. However, this tier of government has since experienced a continuous erosion of its original competencies in favor of the federal government. This is the consequence of allowing concurrent legislation for a number of responsibilities (according to Articles 72 and 74 of the Constitution), and of the principle of federal law overriding state law. Even in areas of primary state responsibility, the Länder’s competence has been reduced by increased sharing of responsibilities and joint decision making.

Although the German Constitution makes some attempt to divide government functions among the tiers vertically (exclusive competencies are defined for the federal government), its approach to federalism differs typically from the models of the Anglo-Saxon world. At the central level, emphasis is laid on legislative functions, the allocation of financial resources, and the formulation of policy guidelines. States and local governments are generally in charge of implementing and administering policies. Lower levels of governments often execute policies on behalf of higher levels, where financing is sometimes tied to the function performed, with corresponding grants or cost restitution. Federal legislation also requires that some functions be financed by the lower tiers from own resources and without compensation (for example, subsidiary welfare, Sozialhilfe). Central administration is less developed in general, and the states bear the brunt of administrative responsibilities in Germany (including those for tax administration). This particular division of functions—central decision making with decentralized execution—has been labeled the horizontal approach to federalism in contrast to the vertical model of the Anglo-Saxon world (Spahn, 1978b). However, as in other federations, some important government functions—such as defense—are also assigned in an exclusively vertical fashion.

As regards financial arrangements, the horizontal distribution of functions is matched by the prevalence of revenue sharing. All major taxes (income and corporate income taxes and the value-added tax—VAT) accrue to federal and state governments jointly. Legislation on taxes is uniform and centralized. Parliaments of regional jurisdictions have no power to legislate on national taxes, although some smaller taxes continue to be assigned to state or local governments. All taxes are assessed according to the same national tax code—in particular as regards the tax base.1 Virtually every law affecting the interests of the states has to pass the Bundesrat (lower house), the states’ legislative assembly, which—unlike the equivalent in other federations such as the United States, Canada, or Australia—is a true states’ house in the sense that its members are appointed by state governments, recalled by them, and strictly bound to the directions of their respective authorities. The status of the Bundesrat in federal legislation has given the German states jointly a very strong position, which counterbalances the loss of individual state sovereignty in specific areas. Since the political majority in the Bundesrat is often distinct from that of the Bundestag (upper house), party-political confrontations dominate the conflicts between the center and the regions.

Expenditure Assignment

As to the vertical distribution of responsibilities, the Constitution assigns defense, foreign affairs, citizenship, immigration and emigration, international treaties, currency matters, federal transport, and postal and telecommunication services to the federal government. The states are responsible for remaining areas such as culture, education, law and order, environmental and health policies, as well as regional economic policy. Municipalities have responsibility for communal services (sewerage, for example), local health facilities, sports and recreation, school building, housing, and road construction. Yet, given the above-mentioned high degree of horizontal integration of functions, this division of responsibilities is not fully reflected in the distribution of public expenditures across levels of government. Social policy (including health and education), for instance, is implemented at all levels of government. The same is true for investment in infrastructure (roads, communications, and construction) where responsibilities are shared. Since higher levels of government tend to delegate the execution of many of their functions to lower levels, outlays by level of government are a poor indicator of responsibilities. For instance, local governments disburse about two-thirds of all public capital expenditure, much of which is commissioned by higher levels of government.

The current distribution of public expenditures among layers of government is presented in Table 1.

Table 1.Germany: Public Expenditures by Level of Government, 1995(In percent of total expenditures of territorial authorities)
European Community share3.0
Federal government34.1
Local governments26.3
Total of territorial100.0
Memorandum items:
Social security funds57.0
Special funds5.3
Sources: Federal Ministry of Finance (1996, p. 328); and authors’ calculations.
Sources: Federal Ministry of Finance (1996, p. 328); and authors’ calculations.

Tax Assignment and Revenue Sharing

In Germany the power to legislate specific taxes has to be seen as totally distinct from the right of each layer of government to appropriate the proceeds from these taxes. Tax legislation is fully centralized. Tax assignment to specific levels of governments is determined by the Constitution, and only minor adjustments in these assignments may be made through federal legislation. Major revisions of federal financial arrangements can be made only through an amendment of the Constitution requiring a two-thirds majority in both houses of the federal parliament.

The significance of taxes directly assigned to each layer of government is small. The main federal taxes (roughly 17 percent of total taxes) are excises, the most important of which are those on mineral oil, tobacco, and alcohol (except beer). The federal government has also the right to levy a surcharge on income taxes, which has become more important recently.2 The main state taxes (5 percent of total taxes) are the motor vehicle tax and the net wealth tax.3 Apart from the local business tax,4 municipalities levy property taxes as well as communal levies on public services (utilities). Local governments collect about 7 percent of all taxes.

All of the most important revenue sources are shared in Germany. The wage and assessed income taxes, the corporation tax, and the VAT, which yield almost three quarters of total tax revenue (71 percent of total taxes in 1995), are all jointly appropriated. In addition, the local business tax—although officially not a joint tax—is shared by all levels of government, and a part of the revenue of the federal mineral oil tax is granted to Länder governments in order to subsidize their regional public transportation. From its share of the VAT, the federal government has to finance Germany’s contribution to the budget of the European Union.

The vertical distribution of income taxes is set by the Constitution (Table 2) and, except for grants, any adjustment of the vertical distribution of public funds is exclusively effected through the shares of the VAT to be renegotiated between federal and state governments when-ever revenue-expenditure relativities for the federation and the Länder will diverge. The result of this bargaining is cast into a federal law requiring the consent of the Bundesrat.

Table 2.Germany: Vertical Distribution of Joint Taxes, 1997(In percent of revenue collected)
Joint TaxFederalStatesLocal
Personal income tax42.542.515
Corporate income tax50.050.00
Value-added tax50.549.50
Local business tax151580
Sources: Grundgesetz; and Federal Ministry of Finance (1996, p. 136).

The shares result from a formula apportionment and are rounded.

Sources: Grundgesetz; and Federal Ministry of Finance (1996, p. 136).

The shares result from a formula apportionment and are rounded.

The horizontal distribution of income taxes is based on a derivation principle, that is, it follows the regional pattern of tax yields according to the residence principle, with special rules for the apportionment of the corporation tax. The regional distribution of VAT is mainly on a per capita basis (three quarters), which already implies a strong implicit equalization effect. Moreover, up to 25 percent of the VAT can be used for even more explicit equalization (see section on Horizontal Grants and Equalization).

The vertical distribution of resources, according to source and transfer category, is presented in Table 3 for 1995.

Table 3.Germany: Sources of Revenue of the Tiers of Government, 1995(In percent of total revenue of each tier)
Revenue SourceFederalStateLocal
Exclusive taxes3095
Shared taxes1596326
Unconditional grants618
Specific purpose grants915
Other revenue111336
Total revenue100100100
Memorandum item:
Percentage share of total outlays financed by borrowing10.88.32.6
Sources: Federal Ministry of Finance (1996); Deutsches Institut für Wirtschaftsforschung (1996); and authors’ calculations.

Shared taxes include the full amount of the local business tax, since 20 percent of its revenue are passed from municipalities to the federal and Länder governments.

Sources: Federal Ministry of Finance (1996); Deutsches Institut für Wirtschaftsforschung (1996); and authors’ calculations.

Shared taxes include the full amount of the local business tax, since 20 percent of its revenue are passed from municipalities to the federal and Länder governments.

Vertical Grants and Cooperative Federalism

There are vertical grants that imply federal cofinancing of specific state projects. These grants are conditional, and operate within a complex network of interstate cooperation. Such cooperation is governed by a great number of treaties and agreements among authorities, and cannot be discussed in detail here. Only the two most important constitutional provisions for policy coordination may be noted: joint tasks—that imply joint decision making and responsibility sharing, in combination with joint planning and financing—and specific grants-in-aid. These are features peculiar to the German federal arrangements.5

These elements of cooperative federalism were introduced in 1969 when it had become clear that federal legislation alone was not sufficient to coordinate policies at the central level. The federal division of functions—with framework legislation assigned to the center and the implementation of policies to the lower tiers of government—appeared to be inadequate to ensure coordinated stabilization policies.6 The model also precluded the federal government from setting guidelines or prerogatives in those areas in which policies cannot be controlled by legislation, namely the provision of public goods and services, especially public infrastructure. It was in these policy domains that the planning and spending functions attributed to the Länder proved more important than the legislative functions assigned to the federal government.

As mentioned earlier, the two instruments created in 1969 were joint tasks according to Articles 91a and 91b and grants-in-aid according to Article 104a(4) of the Constitution. Joint tasks are determined for five policy areas.7 Grants-in-aid are given to the states for regional and local investments within certain policy areas to be defined by federal law or by federal-state agreement. Again, the unifor-mity-of-living-conditions principle is visible in these arrangements, as the Constitution stipulates that such grants should be used only for equalizing regional disparities, for stabilization, and for stimulating growth.

The new provisions have granted a legal basis for earlier practices by which the federal government had provided funds to the Länder on a bilateral basis. The new instruments stress multilateral agreement instead—at least for the joint tasks—which is established within so-called planning committees in which the federal government shares the votes with all of the states. All state projects adopted by the federal government and a majority of states are jointly planned and financed. These instruments have increased the scope for central government intervention in many ways—not only through its impact on the planning process itself (in particular on the selection of projects) but also through the potential threat to withdraw federal cofinancing, which usually covers half of the costs.8

Among the states, the informal conference of the states’ prime ministers is perhaps the most conspicuous example of coordination. Similarly, there are conferences of ministers for special subjects, in particular the conference of the ministers for education and culture, which allows a harmonization of education despite potential political differences among the states.

Furthermore, the German federal system utilizes vertical general revenue grants designed to support the poorer states of the federation. Before unification these unconditional grants, called federal supplementary grants, rendered to the Länder by the federal government were only of minor importance. They were made largely redundant by the provision that allows negotiated adjustments in the federal and state shares of the VAT. However, following German unification,9 asymmetrical vertical grants have become much more important. While taxable capacity was (and still is) significantly lower in the east—because of low productivity, higher unemployment, and short-time work—demands for government services were (and still are) very large. This constitutes a rationale for compensation through interregional fiscal transfers and for stronger involvement of the federal government.

The colossal financial needs of east Germany put the strength of the west German economy to a severe test and had also enormous repercussions on fiscal federal relations. Western states initially resisted pressure to have their eastern counterparts participate in the horizontal equalization scheme (see the following section). In order to have time for renegotiating intergovernmental financial relations and to achieve a fair burden sharing between tiers of government, vertically and horizontally, the Treaty on Unification stipulated that a new set of rules was to be instituted not earlier than 1995.

For an interim period between 1990 and 1994, the extrabudgetary German Unity Fund was created as a temporary device. It strengthened the inadequate revenue basis of the eastern Länder through unconditional grants. During 1990–94, DM 143 billion was channeled through this fund to the eastern states. Of the latter amount, roughly DM 50 billion represented contributions from the federal government, DM 16 billion came from western state budgets, and the remainder was financed through borrowing from capital markets. The federal government and western state and municipal authorities serviced these loans in equal proportions. Further income transfers supporting eastern governments and citizens included specific purpose payments by the federal government, investment credits of the European Recovery Program (ERP), direct transfers from the west German unemployment insurance scheme and the pension funds, and direct payments from the western Länder. Table 4 illustrates the transfers and benefits granted by the western governments to the eastern states and their citizens directly (through the channel of social security contributions). These transfers and benefits do not provide a complete picture of the full scale of interregional support accorded to the east German economy. Support was also provided by specific purpose institutions created to facilitate transition from a socialist to a market-oriented economy. The more important of these institutions were the Treuhandanstalt and the Kreditabwicklungsfonds.10

Table 4.Germany: Public Transfers to East Germany
(In billions of deutsche mark)
Federal government75.795.9117.8120.4156.5
States and municipalities of west Germany5.
German Unity Fund35.033.935.234.69.5
European Union4.
Social insurance funds1
Pension scheme5.612.316.922.228.5
Unemployment benefits24.638.539.527.623
Total transfers2134.4164.1170.8173.5211.5
Tax revenue in east Germany328.733.134.942.650.5
Net transfers105.7131.0135.9130.9161
(In percent of GDP)
Total transfers to the east
Of west Germany5.
Of east Germany65.262.554.448.955.6
Net transfers
Of west Germany4.
Of east Germany51.349.943.336.942.3
Sources: Sachverständigenrat (1995, S. 151); and authors’ calculations.

Transfers to cover shortfall of social security insurance contributions and outlays of social insurance funds.

Without double-counting of items.

East German tax revenue accruing to the federal government.

Sources: Sachverständigenrat (1995, S. 151); and authors’ calculations.

Transfers to cover shortfall of social security insurance contributions and outlays of social insurance funds.

Without double-counting of items.

East German tax revenue accruing to the federal government.

Horizontal Grants and Equalization

A closer look at the horizontal distribution of revenue among states shows that equalization occurs through three main processes, also depicted in Table 5:

  • First, the allotment of shared revenue to individual states strongly alleviates original differences in regional tax potential—in particular, the distribution of VAT. Up to one quarter of the states’ VAT share is used to support financially weaker states. Their fiscal capacity is supplemented up to 92 percent of the states’ average tax revenue per capita through these portions. The remainder (three quarters or more) is distributed according to the population of the states.

  • Second, there is a particular feature of German federalism, the Finanzausgleich, which is a horizontal scheme of interstate equalization without central government interference. Interstate equalization is achieved through a specific set of rules governing a “brotherly” second-round redistribution of means among the states themselves.

    The process starts from a definition of a state and local fiscal capacity measure for each state, which is roughly the sum of state tax revenues with minor corrections for special burdens and local tax revenues adjusted for population density, the degree of urbanization, and so forth. This measure is then related to an equalization standard for the same state, which is derived from the average per capita fiscal capacity of all participating states multiplied by the population of that state. Any shortfall of fiscal capacity in relation to the standard is equalized in steps with graduated rates. A uniform average is not secured, yet there is a guarantee that fiscal capacity (including equalization payments) should reach at least 95 percent of the average for the states as a whole. Equalization payments are made by those states whose fiscal capacity exceeds the standard, again in graduated contributions. The marginal levy is 66.6 percent of per capita fiscal capacity in excess of average fiscal capacity. Fiscal capacity above 110 percent of the average is even “taxed” at a rate of 80 percent. The system works as a clearing mechanism, that is, payments made by the financially stronger states always equal the sum of receipts of the weaker states.

  • Third, the federal government provides a variety of asymmetrical vertical grants that favor certain regions. The following types of federal supplementary grants (Bundesergänzungszuweisungen) can be distinguished: grants are given to financially weak states in both east and west. These funds make up for the shortfall of revenue, after interstate equalization, of 90 percent of average fiscal capacity per capita. Grants are also given to some of the western states in order to offset losses they suffer as a result of the inclusion of the eastern states in the interstate equalization scheme. Another type of grant is provided in response to the “special needs” of some of the states.11 Additionally, the severely indebted states of Saarland and Bremen receive financial aid for the amortization of outstanding debt. Finally, the eastern states obtain additional grants-in-aid for a ten year period to enable them to promote investment and economic growth.

Table 5.Germany: Financial Resources of German States—Equalization in Stages
State Share ofCriteria for Horizontal DistributionHorizontal Equalization Effect
Primary levelPersonal income tax (42.5%)Residence principleWeak
Corporate income tax (50%)Modified residence principleWeak
VAT (35%)
Of which 75%Per capita basisStrong
25%Equalization formulaVery strong
Local business taxRegional pattern of tax yieldNone
State taxes (100%)Regional pattern of tax yieldNone
Secondary levelInterstate equalizationPayments to or from states with less or more than average revenues per capita (zero-sum clearing)Strong
Tertiary levelAsymmetrical vertical grants from federal government
UnconditionalFederal supplementary grantsStrong
ConditionalJoint tasks and grants-in-aidModerate

Initially, the western states had not allowed their eastern counterparts to participate in the horizontal equalization arrangements. The scheme extended to the eastern states without modification would have turned all the former beneficiaries of equalization payments in the west into contributors. As regards the interstate equalization scheme, it was temporarily effected for the two groups of states in isolation—waiting for a final solution. In order to reduce west-east transfers at the second level of revenue distribution, VAT shares between the federal and the state governments were changed from 63/37 percent to 56/44 percent,12 which increased significantly the scope of implicit equalization at the first level. The eastern Länder were fully integrated in the horizontal equalization scheme beginning in 1995. Each state has its own transfer systems for equalizing fiscal capacity among the local authorities within its jurisdiction (kommunaler Finanzausgleich). These schemes take the varying regional economic structure into account, and they are more strongly based on needs than interstate equalization.


Originally, the Law on the Bundesbank had restricted central bank lending to the federal and state governments to a relatively small amount of short-term loans. Institutional limits on deficit financing in Germany now ensue directly from the Maastricht Treaty. Direct government borrowing from the central bank is prohibited, as is privileged access of public authorities to financing institutions. Furthermore, the Maastricht Treaty—under its excessive deficit procedure—considers whether or not the public deficit of member states exceeds government investment expenditure. This provision was copied from the German Constitution, which restricts federal government borrowing to the “amount of projected outlays for investment purposes in the budget” (“golden rule”). Similar provisions apply to Lä nder budgets in accordance with state constitutions or legislation. Local government borrowing is tied to their cash flow and is subject to state control.

Budget constraints thus appear to be rather stringent in Germany. Notably, the “quasi-constitutional” limits to central bank financing were often praised as being the reason for low inflation, a strong currency, and the financial stability of the German public sector. In principle, this nexus cannot be denied—especially as legislation had rendered the Bundesbank legally independent from federal and state intervention. Yet one could argue that the system had not been put to any severe test in the past and that it had worked largely because it was based on a consensus formed by all political parties and interest groups on the historical experiences of hyperinflation. The test of German unification made it clear, however, that judicial control of budget deficits is difficult to achieve—even with constitutional constraints.

However, the budget constraint had been “softened” in many respects even before unification:

  • First, it is far from clear what is meant by “investment purposes.” In some instances, it is possible to redefine current outlays so as to represent investment outlays without much difficulty.

  • Then, an amendment to the Constitution enacted in 1969 permitted the federal government to raise loans to combat “disturbances of general economic equilibrium.” This rule is even more difficult to monitor in quantitative terms. The provision was introduced in the heyday of Keynesian demand management. Application of this rule reached its climax only recently, however, when “disturbance of general economic equilibrium” was interpreted as relating to the consequences of unification.

  • Recently, the contracting out of public infrastructure investment to private enterprises has become fashionable as a window dressing or deficit-reducing device for public budgets. Private investors who—in view of government guarantees—will bear no entrepreneurial risk are asked to build and prefinance public infrastructure projects, such as roads or bridges. Upon completion of the work, the government redeems the building costs over a certain period and assumes all financial charges related to the project. This accords short-term relief from fiscal pressure under a public budgeting system that is exclusively based on cash accounting, but at the cost of reducing the room for fiscal maneuver in the future.

  • Moreover, it is noteworthy that the tiers of government differ considerably as to the characteristics of their creditors. While the federal stock of debt is mainly in the form of tradable bonds, state governments (to the larger part) and local governments (almost entirely) rely on direct bank loans to finance their deficits. There is no municipal bond market as in the United States, for instance. It is therefore difficult to impose market discipline onto the borrowing of lower levels of government, and this explains the need for more explicit forms of regulation and surveillance.

  • Finally, much of the lending comes from state-controlled banks or the local savings banks owned by municipalities.13 This could be considered a form of “connected borrowing” by public authorities.

Central bank independence has closed the door to easy financing of the budget through money creation, and it has fostered budgetary discipline of the German public sector in the past. Nevertheless, it should be clear that deficit financing is softer than may appear at first sight. Restrictive constitutional rules and monetary policies have not prevented the public sector from running significant deficits since the early 1990s.

Table 6 shows government borrowing and the accumulated debt by level of government. The most important off-budget item is a sinking fund, the so-called Inherited Burden Fund, which carries all debt and liabilities inherited directly or indirectly from the former German Democratic Republic (Treuhandanstalt, Kreditabwicklungsfonds, and East German local housing projects).14 The repercussions of German unification on deficit financing and public debts become apparent if the gross debt/GDP ratio of 41.8 percent in 1989 is compared with the ratio of 60.3 percent by the end of 1996. Interestingly, Länder and local governments only contributed about 2 percentage points to the total increase of the public debt ratio of 18½ percentage points. Thus, the federal government is essentially footing the bill for unification.15

Table 6.Germany: Public Debt of Different Levels of Government, End of 1996
Level of DebtDeficit
In billions of deutsche markIn percent of GDPIn billions of deutsche markIn percent of GDP
Levels of government
Off-budget funding
Inherited Burden Fund3329.4−7−0.2
European Recovery Program341.030.1
German Unity Fund842.4−3−0.1
Federal Railways Fund782.200.0
Sources: Deutsche Bundesbank (1997); Sachverständigenrat (1996); and authors’ calculations.Note: Preliminary data. Minus signs indicate surpluses. The Maastricht definition of general government gross debt differs slightly from the data in this table.
Sources: Deutsche Bundesbank (1997); Sachverständigenrat (1996); and authors’ calculations.Note: Preliminary data. Minus signs indicate surpluses. The Maastricht definition of general government gross debt differs slightly from the data in this table.

Administrative Structure

Tax Administration

In addition to assigning expenditure, revenue, and legislative competencies among the different tiers of government, the Constitution determines (Article 108) which layer shall be responsible for the administration of taxes, that is, who should be in charge of collecting, handling, and spending the budgetary means.

The states bear the brunt of tax administration. The federal government only administers customs duties, fiscal monopolies, excise taxes subject to federal legislation (including VAT on imports), and charges imposed within the framework of the European Union. All other taxes are administered by revenue authorities of the Länder. To the extent that taxes accrue wholly or in part to the federal government (joint taxes), state authorities act as agents of the federation. Where the revenues accrue exclusively to local governments, the administration of such taxes is wholly or partly transferred by the states to their municipal authorities.

Both federal and state fiscal administrations are organized along a three-tier structure, comprising overall guiding authorities, intermediate supervisory authorities, and local execution authorities. At the intermediate level, the Regional Finance Offices act as both federal and state authorities. They have departments for taxes, which are desig- nated according to the principles mentioned earlier. The federation assumes the costs related to administering federal taxes; all other costs are the responsibility of the states. Although they work under one roof, the departments of the Regional Finance Offices are strictly separate as to their tasks, organization, staff, and budget.

To ensure uniform standards of tax collecting and auditing throughout the nation, there are several coordinating bodies that work mainly on the basis of informal agreements. The statutes concerning the tax administration personnel and personnel training are also illustrative of the German model of cooperative fiscal federalism: Operating within the framework of a Federal Law on the Training of Revenue Officers, passed in 1961, each state is required to set up, on its own, the institutions and the necessary provisions to train qualified staff.

Budget Formulation and Implementation

The Constitution stipulates in Article 109 that the Federation and the Länder will be autonomous and independent from each other as to their fiscal management and budgeting. However, the tiers of government are obliged to take due account of the requirements of overall equilibrium—which is achieved by federal legislation requiring the consent of the Bundesrat.

The Constitution (Article 110), as well as a federal law on budgetary principles for the Federation and the Länder,16 coordinate the budget process by setting uniform principles to be observed by all authorities. Such principles derive from general provisions (such as the principles of gross estimates, comprehensiveness, unity, clarity, periodicity and antecedence, efficiency and cost effectiveness, and authorization to spend and to commit resources) to more specific rules regarding the preparation of the budget, accounting and the rendering of accounts (including the classification of the budget), auditing, and rules applying to special funds set up under federal or state legislation. Also, the budget process has been made more transparent, in order to assess the budget’s effects on the economy. The second part of this legislation contains regulations such as multiyear financial planning and the exchange of budget-related information.

The annual budgets (calendar year) are presented as part of a medium-term financial plan, which is established by the Financial Planning Council representing all three tiers of government. The Council’s objective is to reach agreement on the coordination of general budgetary policy and to support the federal government in its statutory task of ensuring that budgetary policies are consistent with macroeconomic stability. The Council is, however, bound by the Constitution to respect the autonomous and independent fiscal administration of states and the right of self-governance of municipalities. It therefore acts through recommendations that are nonbinding, yet have an impact on budget estimates and budget execution (including the level of borrowing).


Macroeconomic Management

Toward the end of the 1960s, Germany had pioneered legislation on macroeconomic management. A Stability and Growth Law was enacted that commits the federal government to certain macroeconomic targets17 and that provides specific instruments enabling the authorities to pursue demand management policies effectively.

Inter alia, the law authorized the federal government to issue decrees, with approval of the Bundestag, to amend the income tax at short notice, including withholding taxes on wages and the corporate income tax. An income tax surcharge or rebate, up to a maximum of 10 percent can be introduced on condition that a disturbance of overall equilibrium exists or is about to emerge. The surcharge benefits the federal budget, not those of states and municipalities. The law also allows the government to accord temporary income tax relief for investment.

In addition, an intergovernmental Business Cycle Council was established to guide governments in coordinating their budgets (apart from medium-term planning), and an attempt was made to influence the social partners through concerted action. Yet, formal coordination essentially failed—except for the very beginning—as the crises of the early 1970s were found to be structural in nature and the range of policy instruments provided by legislation was inappropriate for such purposes. Furthermore, Keynesian demand management had rapidly become unfashionable in Germany, and the instruments provided by the Stability and Growth Law were in the doldrums.

Fiscal federal arrangements allowed the federal government to take a lead in reacting to economic shocks provoked by the oil crises, and budgetary and monetary policies promoted the restoration of macroeconomic stability. During the 1980s, after the second oil crisis, supply-side policies dominated under conservative-liberal federal governments. The rapid expansion of social expenditures was curbed and financial stability was maintained at all levels of government—supported by significant real growth of the economy. However, attempts failed to put the social security system on a sound and sustainable financial basis. Within five years after unification, the consolidation success faded away and the ratio of total general government outlays surpassed 50 percent of GDP—roughly the same level as in 1982.

Moreover, it also became clear in the 1990s that the existing intergovernmental institutions (in particular, the Financial Planning Council) neither were suited to nor had the necessary experience to face the dual challenge of German unification and European integration. One could have expected that the burden of unification would be shouldered by all levels of government in equal proportions. As was discussed earlier, this was not the case and the federal government had to incur disproportionally high expenditures. As a result, the financial and the political weight of lower levels of government in Germany was weakened. Moreover, a coherent economic policy strategy is still lacking that would put the east German economy on a sustainable growth path and allow it to catch up with the west in the foreseeable future.18

As massive income transfers to the east are likely to continue for a long time, there is a risk of political tensions between the eastern and the western Länder. Additionally, both parts of Germany are plagued by unemployment that has reached record levels unprecedented since World War II.

As to European integration, the federal government has taken the lead in trying to accomplish the macroeconomic and budgetary convergence criteria of the Maastricht Treaty, which is a precondition for the start of the European Economic and Monetary Union (EMU). Moreover, the German Federal Minister of Finance has sponsored a “Stability Pact” to promote budgetary discipline after the creation of the union. The pact foresees sanctions in the form of fines for member states that exceed the predetermined public deficit limits. Although the federal government is responsible for general government debt in Germany according to the Treaty, it has no power to interfere with the states’ autonomous budgeting. So far, there is no agreement with states and municipalities on how a global public sector deficit could be “apportioned” onto tiers of government—both vertically and horizontally.

Structural Reform

The restructuring of intergovernmental financial relations following unification was, at best, a modest alteration. Certainly, it does not constitute a structural reform. Any major revision of federal fiscal arrangements is constrained by the fact that different political majorities reign in both houses of parliament. This form of “divided government” makes it relatively easy for interest groups to block reforms that could jeopardize their privileges by exercising their influence on one of the two largest German parties (the Christian Democrats and Social Democrats). Regional issues rank high on the agenda of the Bundesrat, and this institution is often used as a place for bargaining along party lines.19

More recent developments have revealed that German fiscal federal arrangements exhibit serious flaws as regards equity, efficiency, transparency, and accountability (see also Table 7 and Figure 1).

Table 7.Germany: Fiscal Equalization Among States, 1995
Relative Fiscal Capacity Per Capita (Average = 100)
Public revenue per capita
Without VATAfter VAT distributionAfter interstate equalizationAfter federal grantsRank after equalization
Baden- Württemberg115.7107.1103.094.212
North Rhine-Westphalia114.2105.4102.493.714
Lower Saxony96.294.297.892.916
Mecklenburg-West Pomerania47.082.395.0119.83
Sources: Deursches Institut für Wirtschaftsforschung (1996); and authors’ calculations.

Eastern states.

Sources: Deursches Institut für Wirtschaftsforschung (1996); and authors’ calculations.

Eastern states.

Figure 1.Germany: Per Capita Fiscal Capacity of States Before and After Equalization

(In percent of average)

Sources: Federal Ministry of Finance; and authors’ calculations.

1 Eastern states.

  • Although financial settlement among states has had a rather strong equalizing effect in the past, initially the mechanism had worked reasonably well. Yet the burden of the settlements was consistently shifted onto two states—Baden-Württemberg and, in particular, Hesse—while all others either benefited or were exempt from contributing major amounts to the scheme. This had led to political tensions among the states even before unification. At present, the three-stage equalization scheme reverses the order of initial fiscal capacity. The federal supplementary grants provide the eastern states with a fiscal capacity far above the national average. In real terms, they even command greater resources since their costs tend to be below those of their western counterparts. In addition, the dynamics of the debt of the former east German government are staggering: Starting from zero debt in 1990, in only five years the eastern states have reached 70 percent of the per capita debt of their western counterparts; and east German municipalities have attained 80 percent of the per capita debt of their western counterparts.

  • Tax sharing and an equalization method that provides resources to each state close to average fiscal capacity per capita entail severe disincentives as to the use and development of own revenue sources. Relatively rich states are “punished” for strengthening their tax base—for example if they promote private investments by delivering appropriate public infrastructure. On the other hand, the poorer states have little incentive to combat structural weaknesses of their regional economies and to pursue prudent fiscal policies that are suited to their taxable capacity. The uniformity of living clause of the Constitution renders it unlikely, however, that this feature of the German federal machinery will be altered.

  • Inefficiency through a high degree of interstate equalization is exacerbated by recurrent explicit bailouts of the highly indebted states through the workings of federal supplementary grants. The states of Saarland and Bremen, for instance, receive federal grants that are explicitly aimed at relieving the burden of interest payments on their excessive debt.20 Lack of fiscal discipline on the part of certain states is thus rewarded by larger transfers, which is likely to create moral hazard for other jurisdictions.

  • The ever-increasing complexity of an interdependent network of shared taxes and equalization grants and of expenditure functions and decision-making institutions renders it impossible for voters and taxpayers to identify which government spends or taxes, and for what purpose. This breaks the benefit-tax link that is essential for enhancing efficiency in the provision of local public goods. The lack of fiscal accountability by regional authorities is probably one of the most important drawbacks of cooperative federalism.

  • Efficiency gains of decentralization are also sacrificed to the extent that taxation is uniform throughout the nation—in spite of some taxing autonomy of municipalities. Own revenue competencies for the Länder or discretion to levy state surcharges on federal taxes would contribute to remedy this deficiency, but are unlikely to be considered under the present Constitution. Also, tax-base sharing could be an alternative to relying on joint taxes almost exclusively. The income tax would be a natural candidate. This could enhance efficiency and accountability provided that the corresponding revenue can be used exclusively by the taxing authority—and is immune to attempts to embody it in the interregional equalization machinery.

  • Further inefficiencies result from the German system of tax administration. Since the salaries of auditors are paid by the states, Länder with an above-average tax capacity have little incentive to detect and prosecute tax evasion. With transfer rates as high as 80 percent onto state tax collections, additional proceeds would be largely siphoned off by higher payments into the Finanzausgleich.

  • In addition, uniformity in legislation is likely to hamper innovation and structural reform in public management. Competition among governments could encourage authorities to better serve the needs of citizens and to improve the quality of services, but uniform rules, equal salaries for public servants, or invariable prescriptions of a Civil Service Act, and so on are likely to restrict experimentation among jurisdictions and thus hinder public sector reform.

In summary, one may say that interregional solidarity is perverted where the principle of uniformity of living conditions entails a lack of fiscal discipline. This is true to the extent that lack of fiscal discipline is rewarded by larger transfers from federal and state governments. The marginal levies for interstate equalization are much too high. In order to strike a balance between equalization and the legitimate inclination of richer states to spend more of their own tax revenue themselves, one could imagine the equalization formula to incorporate ceilings that would limit the absolute amount of equalization payments for individual states.

Furthermore, there appears to be need for an equalization scheme that works on the basis of objective criteria that cannot be manipulated by recipient governments.21 And a credible commitment not to bail out state or local authorities in financial difficulties would be an important step to curtail the moral hazard inherent in the financial equalization process.22

Finally, the Constitution (Article 29(1)) allows for a reorganization of the federal territory in order to ascertain that states are large enough to provide the functions incumbent on them efficiently. For example, if Hamburg, Bremen, and Saarland would merge with neighboring states, more homogeneous entities could be created that require less interstate equalization. Also, administrative costs could be reduced. However, an interstate treaty aimed at merging Berlin and Brandenburg was rejected by an obligatory referendum in 1996. It is therefore unlikely that politicians will launch further merger projects for the German states in the near future.


German fiscal federal relations have created a high degree of homogeneity as to the regional availability of public infrastructure and government services. This is the basis on which the economy thrives. Financing public services is mainly based on shared taxes and equalization arrangements stressing the uniformity of living conditions in the whole nation, and on horizontal cooperation among layers of government. This has not prevented regional authorities from exerting an influential role within the realm of their own jurisdiction and at the level of the federation.

The spirit of these arrangements has survived the strain placed on the system by German unification. However, the experience has revealed the solidarity among the Länder to have limitations. VAT sharing with its implicit equalization effects, as well as asymmetrical vertical grants by the federal government, were preferred to explicit horizontal redistribution as embodied in the interstate equalization scheme. These developments have, however, strengthened the influence of the federal government through its increased role in intergovernmental finance.

However, the German system of intergovernmental fiscal relations has a number of flaws that reduce its efficiency and impinge on interregional equity. They result from a strict interpretation of the uniformity of living conditions mandated by the Constitution. The opportunity to correct the system of fiscal federalism in the wake of German unification was missed. A further chance may appear through the need to reconcile the budget performance of autonomous German governments at all levels with a general criteria for budget discipline as imposed by the project of European Monetary Union.

However, some discretion is accorded to local governments in the setting of tax rates.

At present (1997), an income tax surcharge of 7.5 percent on all personal and corporate income tax payments is applied to finance costs resulting from German unification (“solidarity levy”). The proceeds of this surcharge accrue solely to the federal government. Initially, surcharges on income taxes were introduced toward the end of the 1960s as a countercyclical device for demand management, but became soon outmoded.

The latter tax is no longer assessed after the Constitutional Court had declared that the rules for defining the tax base discriminate against specific types of assets—which does not conform to the Constitution.

There is strong political demand to abolish the local business tax in order to strengthen private enterprises. The minor part of it, the business tax on working capital, will not be collected from 1998 on if the bill introduced by the federal government passes both houses of parliament. Municipalities would be compensated by a share of VAT revenue, thus intensifying further the integrated system of joint taxation.

For a fuller discussion, see, for instance, Reissert (1978).

The centralization reached its peak at the end of the 1960s, when Article 109 of the Constitution was amended (1967), the Stability and Growth Law was enacted (1967). a Business Cycle Council and a Financial Planning Council were established, and the principles governing the budgets of federal states governments were harmonized (1969).

These are (1) university construction, (2) regional policy, (3) agricultural structural policy and coast preservation, (4) planning education, and (5) fostering research, to the extent that these are of supraregional importance.

The federal contribution varies, though. It is 60 percent for agricultural policy measures, and 70 percent for coast preservation.

On October 3, 1990, five eastern states that had formerly been administered centrally by a socialist government joined the Federal Republic of Germany, adopting its complete legal system. East Berlin was merged with west Berlin that Had formerly existed as a west German state under special rule (still being controlled by the Western allies of World War II).

The Treuhandanstalt was a state agency or government trust in charge of privatizing east German businesses, the formerly state-owned corporations. It was controlled by the federal Ministry of Finance. It had a limited existence and was wound up at the end of 1994. The organization left the federal government with a net debt of DM 270 billion, resulting from the massive subsidies given to private investors as incentives to buy firms and to sustain jobs—the capital stock to be privatized was largely obsolete.

The Kreditabwicklungsfonds was created to wind up debt inherited from the former German Democratic Republic government and from currency conversion. When the German economic, monetary, and social union was inaugurated (July 1990), private demand deposits and savings up to a limit per east German citizen were converted into deutsche mark at parity. Savings above this limit and other financial assets and liabilities were converted at DM 1 = M 2. Since the assets of most banks were transformed into deutsche mark at lower rates than their liabilities, net assets of the banking system had to be topped up by claims against this Conversion Fund. These obligations amounted to approximately DM 102 billion (Deutsche Bundesbank, 1993).

These needs reflect the relatively high costs of political administration incurred by small states and the still enormous deficiencies of eastern states as to their public infrastructure.

This differs from the ratio shown in Table 2 because of the impact of a recent technical change in disbursing children’s allowances through the tax system, for which the states had to be compensated.

Often the mayor of a commune is also chairman of the supervisory board of the local savings bank.

For further details, see Föttinger and Spahn (1994).

Off-budget funding is in the domain of the federal government.

This law of 1969 was published in English, together with other relevant material, under the title Federal German Budget Legislation, by the Federal Ministry of Finance, Bonn, November 1988.

These targets are that the economic and fiscal measures of the Federation and the Länder shall be taken in a way that will, within the framework of a market economy, at the same time help to stabilize prices, maintain a high level of employment, and achieve external balance, accompanied by steady and adequate economic growth.

In 1996, economic growth in east Germany slowed down markedly, and was far below projections. Productivity per employee is at 57 percent of the west German level, while net earnings per worker are at 85 percent. See Federal Ministry of Economics (1997, p. 106) for details.

See Alesina and Rosenthal (1995, p. 255) for applying the concept of divided government.—originally used to analyze the balance of power between the U.S. Congress and the President—to the German federal system.

At the end of December 1995, the average debt per capita (including debt of municipalities) of old Länder was DM 8,600. The per capita debt of Saarland amounted to DM 14,800 and that of Bremen to DM 24,700.

The authors have proposed a cost-oriented interstate equalization scheme (see Föttinger and Spahn, 1993). For example, they have pointed out that eastern states have a cost advantage in producing public services, since salaries of public employees are still significantly lower in the east.

For such a commitment to be credible, regional governments would have to control substantial own resources—which is true for Germany—but it would also require some discretion in taxation—which is generally not the case.


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