CHAPTER 2: The Federal Financial Equalisation System:
This chapter will outline the details and complexities of the Federal Financial Equalisation system. In doing so, this chapter will offer greater understanding on the functionality of the fiscal processes that this paper will later address in greater detail. Providing a wider context to the arguments that this paper addresses, this chapter will focus on detailing the four phases of the FFEs.
Following the reunification of Germany, the Federal Republic comprised of 16 federal states, known as Länder. The composition of the Federal structure provides that the Länder are considered an independent level of government, who under the constitution are expected to deliver on certain public and economic obligations (Basic Law, c. VII, art. 70, para. 2). These independent rights and obligations are outlined in the German Basic Law (Grundgesetz), primarily in the constitutional rules on public finance. The Federal Financial Equalisation System (FFEs) dates long before reunification of east and west Germany in 1990, as it had long been recognised that in order to allow the independent states to provide on their obligations and services to regional citizens, they would need sufficient financial resources. Furthermore, it was decided that in the interest of autonomy of the Länder, the states must exercise independent control over their financial resources (Basic Law, c. II, art. 28, para. 2). Therefore, the FFEs was implemented with the intention of equalising Länder revenue and worked towards creating and sustaining equal living standards across all Länder.
Once the constitution had given provision that the Federal states would receive supplementary funding, the FFEs was created and its regulations, with regards to supplementary funding, can be considered in four unique phases of financial equalisation. These phases are outlined below and explained in the following paragraph,
1. First, the national tax revenue is distributed across the two primary levels of government – the regional Länder and the Federation. This first phase is a vertical distribution of tax revenue.
2. Second, the total distribution to the Länder, given under the previous stage, is divided and distributed across all 16 Länder. This phase is known as horizontal distribution.
3. Next, the primary process of equalisation occurs. The tax revenue distributed by horizontal distribution undergoes equalisation between the wealthier and less wealthy Länder in the system. This acts to account for any pre-existing unreasonable burden on the Länder for which the previous stage does not account (Basic Law, c. XI, art. 120a, para. 1). This is known as the phase of financial equalisation.
4. Lastly, poorer Länder will receive additional funding – known as supplementary federal grants (Basic Law, c. X, art. 107, para. 2) – which accounts for unique or uncommon financial factors. For example, this process accounts for unreasonable administrative costs within smaller Länder and city-states (Leibniz-Institut für Wirtschaftsforschung, 2015).
Vertical Distribution
The Basic Law (Grundgesetz) uses the process of vertical distribution to allocate certain tax revenues to the Federation (direct Federal taxes) and others to the Länder (indirect local taxes). In this process, the Federation receives the majority of taxes, including Customs taxes and any Supplementary taxes. While the Länder receive distribution of Property taxes, Inheritance tax and any other indirect product taxes. There are also certain taxes known as joint taxes, such as Income tax and VAT. These joint taxes are split between the Federation and the Länder and it is normal that there is almost an equal split on these taxes between the Federation and the Länder, as these taxes generate the most revenue.
For all remaining, smaller revenue taxes – such as Trade tax; Duties tax; Property Transfer tax – these are distributed between the Federation and the Länder through an apportionment.
Horizontal Distribution
At this stage, the Länder taxation revenue is distributed among the federal states. While some taxes, such as VAT and Corporation tax are split using a process of allotment between the Länder, other taxes are subject to the ‘principle of local revenue’ outlined in the Grundgesetz (Basic Law, c. X, art. 107, para. 1). This principally acknowledges that each state is entitled to the exact sum of tax revenue generated on its territory.
Taxes which are subject to allotment are split approximately, this predominantly effects Corporation tax. The system distributes Corporation tax revenue to all states in which a company maintains business (Basic Law, c. X, art. 106, para. 3), this is done because businesses pay taxes centrally and so this method aims to benefit all states whose territory is used.
However, VAT undergoes a different and more particular process of allotment, which begins the process of equalisation under the current system. A quarter of the VAT tax revenue is distributed as a supplementary fund to the states whose current allotment of revenue per capita is below the national per capita average (Basic Law, c. X, art. 106, para. 5a). As such, this process begins to address the situation of fiscal imbalance and aims to provide equal financial conditions throughout Germany. This allotment is distributed to Länder by assessing how far below the average each state is, Länder who sink further below the average will receive a greater proportion. This method is known as, “linear-progressive topping-up scheduling” (Bundesministerium der Finanzen, 2015).
The remaining VAT revenue is distributed based on the population of the Länder (Basic Law, c. X, art. 106, para. 5a), which in certain areas, once again, has a further equalising effect as some more populous states often fall below the national fiscal averages which the government uses to determine the outgoing allotments.
Financial Equalisation
ADD EQUALISATION EQUATIONS: world bank 1997 text
At this stage of the FFEs, the system begins to give rise to donor- and receiver- Länder. At this stage, there is an adjustment of the distributions made under horizontal distribution in phase two. These adjustments are paid from wealthier states to the less financially secure or “more fiscally burdened” states (Von Aert, 2017). However, the aim of the system is to maintain fiscal autonomy of the Länder and so this phase does not significantly alter the range of receipts among the states (FinanzeGruppe, 2015).
This phase determines which states are eligible for further funding by comparing the financial capacity of the Länder per capita against an average. The financial capacity of the Länder is determined by considering the sum of Länder receipts under the FFEs and the local authority fiscal strength.
In the cases of states with low populations and the city-states of Berlin, Bremen and Hamburg, there is an adjustment in their capacity values as it is recognised that this system assumes that the fiscal cost per capita is the same in all states. This is not the case in low population states and city-states where administrative costs are significantly higher per capita. To combat this, their populations are increased up to a value of 35% when undergoing equalisation.
Once again, this system uses a “linear-progressive topping-up scheduling” (Bundesministerium der Finanzen, 2015) to determine how much wealthier states are above the average and how much poorer states are below the average. Based on these calculations, the exact value of adjustment payments is calculated (FinanzeGruppe, 2015). However, as expressed this process is designed such that it has no effect on the ranking of the Länder, with respect to their financial capacity. The total result of this process is that the range of financial capacities among the Länder decreases and as a result all federal states are much closer to the national average. This demonstrates how the system aims to achieve equitable fiscal scenarios throughout Germany.
Further supplementary funding
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This stage is used as a complementary stage, the funding given in this instance is meant to account for any remaining imbalance among the financial capacity of the Länder. In the case of the eastern Länder that saw accession to the federal system in 1990, this additional supplementary funding is offered to account for any pre-existing financial burdens relating to the partitioning of Germany (Basic Law, c. XI, art. 120a, para. 1). Subject to much criticism, these funds are uncommitted and are labelled as spatially targeted, as their aim is to cover general financial obligations required of the Länder under the Grundgesetz. As such, the Länder themselves are expected to be responsible for the distribution of these funds, it is their sole requirement to ensure that the grants are used to fund investment and not expenditure (Deutsche Bundesbank, 2014).
This final stage of the FFEs also provides the legal basis for the Solidarity Pact which was implemented in 1993 and renewed in 2004. Under the current legal basis, the eastern Länder and Berlin receive special-need supplementary federal grants until December 2019. These grants are meant to be committed and are focused on investment in infrastructure, which in the eastern Länder was reasonably underdeveloped in comparison to the western Länder (Debes, 2015). These grants account for a significant transfer of regional capital and it is here that many donor-states are aiming their criticisms of the system.
The Solidarity Pact was introduced under Helmut Kohl to replace the former German unity fund and sought to boost the financial capacity of the poorer eastern Länder. Effective in January 1995, the Solidarity Pact was agreed on by the governing parties and it was imposed as a 7.5% surcharge to income tax. This, therefore, like others distributive methods uses a similar linear-progressive scheduling as it is of greatest burden to wealthier states rather than less financially secure western states (Süddeutsche Zeitung, 2017). This is because the revenue of income tax in these areas is highest. In this light, it is possible to see why the media received the policy’s implementation critically as it does little to actively dissuade the ‘free rider problem’ and specifically targets over-performing western Länder – who are now beginning to feel the effects of the ‘export’ capital transfers (Süddeutsche Zeitung, 2017).
All in all, it is easy to see how the phases of FFEs have been subject to much debate and how it is feasible that such criticism is reflective of growing hostility and dissension throughout Germany. Primarily, as the current system is infrequently regulated, causing growing over-burdening and unreflective of the current economic status of the Länder.
The next chapter will begin to focus more specifically on the strengths and weaknesses of the current system and will begin to examine regional calls for greater reform of the FFEs. In doing so, it will become clearer whether the system is effective and whether it has achieved its primary aim of creating more equitable financial circumstances throughout Germany.