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You are here: Home > Products > Federations Magazine > October/November > German Länder to control own taxes?

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German Länder to control own taxes?

Reform of fiscal federalism “one of the most difficult issues since unification”

BY FELIX KNÜPLING

Last year, the Federal Republic of Germany introduced the most extensive constitutional reform since its birth. The constitutional overhaul, which Germans call Federalism Reform I, established a new division of legislative powers between the federation and its constituent units, the Länder.

This year, Federalism Reform II is starting where Federalism Reform I left off. In its coalition agreement to form the federal government after the October 2005 elections, the Christian Democrats and Social Democrats agreed that the first stage of reform should be followed by a further step – to adapt financial relations between the Federation and the Länder to the new underlying economic conditions in Germany and elsewhere.

In the first stage of this reform, legislators in Berlin barely touched on the constitutional provisions governing state finances, knowing that to do so would have made the process an impossible task. But even now, the challenge is big. The reform is being handled by a parliamentary joint commission of the lower house – the Bundestag – and the upper house, the Bundesrat. As Christian Democrat leader Norbert Lammert, the Speaker of the federal parliament, put it during the first meeting of the commission in March 2007, the fiscal reform “is surely one of the most difficult issues the federal government and the Länder have had to tackle since German unification.”

Commission to decide on reform
The joint commission is co-chaired by Peter Struck, chairman of the Social Democratic parliamentary group in the Bundestag, and Christian Democrat Günther Oettinger, the premier of Baden-Württemberg. Each house of parliament has delegated 16 regular members to the commission. Four of the Bundestag delegates are members of the federal government. Almost all of the Länder have sent premiers.
The two chambers have agreed on a group of measures in a resolution that ties in with approval of the first stage of the reform. The commission’s mandate includes the tasks of:
•  Developing effective mechanisms to prevent and manage budgetary crises in the face of Germany’s enormous public debt, which totals more than 1.5 trillion euros (more than $2 trillion U.S.).
•  Drafting proposals for the modernization of Federation-Länder financial relations, particularly in the areas of growth and employment policy.
• Strengthening the responsibilities of regional and local authorities, and ensuring they have the
necessary financial resources to carry out their duties.
• Modernizing the administration and grouping together of public services with the aim of enhancing efficiency and reducing red tape.
• Easing the requirements for voluntary mergers between Länder.

Thus far, the commission discussed financial issues during a public hearing in June 2007, with 18 experts it appointed. A second public hearing focusing on administrative issues is planned for November. The aim is to enact final legislation in 2008.

More autonomy for the Länder?
Fiscal law in Germany is predominantly federal law, and the Länder are subject to many restrictions on raising revenues and carrying out expenditures. The country has a mixed revenue collection and
distribution system. The most important taxes – the value added tax, and personal and corporate income taxes – are shared revenue sources for the Länder and the federal government. The basis of these taxes is decided jointly in the Bundestag and the Bundesrat. But the rates and basis for other tax sources belonging exclusively to the Länder, such as inheritance or automobile taxes, also have to be passed by both chambers. Experts estimate that only two per cent of total Länder revenue is autonomous. This comes from the beverage tax (beer tax), entertainment tax, dog tax, and hunting and fishing tax. The only notable exception for total tax harmonization is the local business tax, which each community and city can set independently according to its needs.

Germany’s fiscal federalism is also marked by a very complex financial equalization system aimed at providing comparable standards of living for people in the entire country, as the German Constitution requires. After distributing revenues to the Länder, a system of transfer payments kicks in, bringing the fiscal capacity of each Land to 97.5 per cent of the average. Critics contend that because the degree of fiscal equalization between the states is extremely high, the richer states are discouraged from increasing their efficiency because most of the gains would be transferred to the poorer states. It is also a disincentive for the poorer states to improve efficiency as that would decrease the amount of transfers they received.

REUTERS/Alexandra Beier

The beer tax is one of the few independent sources of revenue for the German regional governments. Drinking this beer is Guenther Oettinger, Baden Wuerttemberg’s Christian Democratic Premier and co-chairman of the parliamentary joint commission to reform Germany’s fiscal federalism.

The lack of Land autonomy on the revenue side and the strong restriction on the spending side which requires the Länder to provide a minimum quality of public services have led the Länder to rely on transfers from the federal government and to use borrowing as the instrument of choice to finance any spending shortfalls. This has contributed to the enormous debt the country has amassed.

The politics of fiscal reform
Some of the wealthier and more economically powerful Länder, ruled by Christian Democratic-led governments, are demanding more autonomy over the raising of income taxes. They prefer to raise their own tax rates on the share of income tax they are entitled to. Obviously, remodeling the revenue system in this fashion would encourage competition. This approach is largely supported by Christian Democrat politicians in the Bundestag and in the richer Länder, and by the Free Democrats.

However, the poorer Länder, especially in East Germany, whose economic capacity is about two-thirds of the average, are very reluctant to introduce more competition. As well, many Social Democrats remain skeptical, referring to the structural differences between the Länder. “Competition requires that the federation, the Länder and the communities are in the same position to fulfill their duties,” Berlin mayor Klaus Wowereit of the Social Democrats said during a Bundestag debate on March 8, 2007. The premiers of the six Länder in the former East Germany accordingly made it clear they do not want to introduce changes to the equalization system. Part of the equalization system is the Solidarity Pact II, negotiated in 2001. Under the terms of the pact, the East German Länder will receive special federal grants totaling 159 billion Euros until 2019, on a yearly declining scale, to enable them to cope with the challenges of unification.

Applying a “debt brake”
One proposal to deal with the debt crisis is to introduce a “debt brake,” or a halt to all borrowing. Another is the introduction of an “early warning system” to avoid unhappy budgetary surprises. But such moves would only help to prevent future indebtedness. Legislators still need to deal with the current debt of the Länder and the federation. Günther Oettinger, co-chair of the commission, proposed the introduction of a special solidarity fund to assist the Länder in reducing the debt. Some Länder argue there first must be agreement about how to avoid accumulating even more debt in the future before considering how to deal with the accumulated debt.

However, the Länder – especially the poorer ones in the east – obviously will face a huge challenge if a debt brake is introduced. Currently, they have had only two ways of balancing their budgets: cutting expenditures, or borrowing more money, thereby increasing their total debt. But cutting expenditures is not a viable option because most expenditures are prescribed by federal law. And if a debt brake is introduced, they will not be able to borrow money any more.

It seems like a no-win situation, but Hans-Peter Schneider, executive director of the Institute of Federalism in Hannover, argues that the East German Länder might be interested in receiving more fiscal responsibility because they know that this will be their salvation. “The Länder need greater fiscal autonomy,” Schneider said. “First, they should have the competency to legislate on those taxes which are attributed to them. Second, they should be empowered to (place a) surcharge on shared revenues to finance specific tasks for a restricted period of time. Finally, they should be able to deal more flexibly in administering federal laws and to deviate from federal standards, which often are very costly for the Länder.” In general, he argued that Germany’s form of federalism needs to be shifted more from an administrative one to a creative, constructive model.

Federalism Reform II will not be completed until 2008 at the earliest. The grand coalition needs to be able to compromise with the Länder to reach agreement on legislation and get it passed in Berlin. When it is, it will represent more than a major step in the development of German federalism. 

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Felix Knüpling is director, Europe programs, for the Forum of Federations. Formerly, he was with the German parliament – the Bundestag – for six years and was a senior staffer in the office of a member of the Bundestag’s foreign affairs committee.