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«Kiel Working Paper No. 1196 Germany’s Fiscal Policy Stance by Horst Siebert January 2004 The responsibility for the contents of the working papers ...»

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processes. The requirement of similar living conditions relates to the aspects that the government can control, for instance the supply of the transportation infrastructure and the school and educational system. These goods provided by the government, not all of them public goods in the strict sense as defined in economics but also merit goods. These are goods judged to be so meritorious that most people want them such as kindergartens or schools, but they depend on the capacity to generate tax revenue. Since this capacity diverges between the federal states, a revenue sharing mechanism has been established providing additional income to the states with a lower tax revenue. This system was in place long before German unification; it applies within West Germany as well.

In horizontal revenue sharing, the Länder with a relatively high tax capacity transfer part of their tax revenue to the poorer countries. Thus, Bavaria gave up 2 bill euro of its tax receipts in 2002, amounting to 8 per cent of its total tax revenue in 2002 (to 6 per cent if the tax revenue of the Bavarian municipalities are also included), whereas Lower Saxony received 0.5 bill euro and Berlin 2.7 bill euro (Table 6). Total horizontal flows amounted to 7.4 bill. Note that the criterion used in the revenue sharing, the power to generate tax revenue, apparently deviates from GDP per capita considerably. Thus, NorthrhineWestphalia, with its GDP per capita at about the German average, makes considerable contributions towards revenue sharing, whereas Bremen with a GDP per capita of 136 per cent is a major recipient. In vertical revenue sharing, the federal layer transfers funds to the Länder (Bundesergänzungszuweisungen);

these flows of 16 bill euro are in addition to the distribution of the revenues of the personal income, the corporate income and the value added taxes.

Furthermore, it should be noted that transfers occur in the form of mixed financing (see below).

30 Table 6: Revenue sharing, bill euro, 2002

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The formula for revenue sharing is complex. As a separate aspect, before the revenue of the value added tax is distributed among the federal states according to the population, the weaker Länder receive part of that revenue beforehand (VAT in advance compensation, Umsatzsteuervorwegausgleich). When this has been done and when the capacity to raise revenue for the federal states is thus determined, beginning in 2005 the marginal fill-up rate for the receiving countries is 75 per cent of the difference from the average. This applies to those states whose capacity to generate taxes is below 80 per cent of the Länder average. It then falls to 70 per cent until a capacity of 93 per cent is reached. In the remaining difference in capacity the fill up rate goes to 44 per cent. The skim-off rate for the paying states is symmetrical. It starts at 44 per cent for the paying states when their capacity to generate tax revenue is just above 100 per cent. It goes up to 70 per cent for a capacity of 107 per cent and then is 75 per cent at 120 per cent of the capacity (German Council of Economic Advisers 2001: 134). The previous arrangement had been declared unconstitutional by the 11 Constitutional Court in 1999. There are additional provisions defining the expenditures needs of states; for instance, the population of city states is weighted with 135 per cent on the assumption that they have higher expenditures per capita. Moreover, the average skim off rate is capped at 72.5 per cent; 12 per cent of an over-proportional increase in tax revenue relative to the last year is not factored into the revenue of the state paying in.

11 Prior to 2005, the fill-up and skim off rates were step wise. For instance, the fill up rate was 100 per cent for a capacity to generate tax revenue of up to 92 per cent below the average. This represented an even greater distortion. The fill up rate then fell to 37.5 per cent which was more incentive-compatible than the new solution.

Together with the supplementary vertical transfers by the federal level it even reversed the ranking of the states in terms of their capacity to raise taxes.

32 Figure 3: Marginal fill-up and skim-off rates in horizontal revenue sharing Fill-up and skim-off rate 110 100 90 80 70 60

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This system sets the wrong incentives. Federal states that succeed in enlarging their tax base and in generating additional tax revenue have to give up part of their additional tax revenue to other federal states. This reduces the incentives to attract firms and economic activities in order to enlarge the state’s tax base, it also weakens the incentive for a long run growth strategy of the individual states. The mechanism helps to cover up political mistakes and does not assign the responsibility for failure to those who cause failure. Moreover, it prevents an institutional arrangement in which the federal states would be given more tax autonomy while at the same time taking over more responsibility for the result of their policies. The incidence of the given set-up of revenue sharing would be less severe if the fill up rate were lowered much more when the states approach the average of the other states. Then the poorer states would be helped whereas 33

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In addition to this formal mechanism of revenue sharing, both the federal government and the Länder must provide aid if one of the federal states becomes insolvent. This is required by the principle of cooperation and support, the Bündisches Prinzip, which is one of the many principles that rule in German public finance. Thus, according to a decision of the Constitutional Court, both the federal level and the Länder had to step in to help when Bremen and the Saarland fell into financial distress (Haushaltsnotlage) in 1992. Actually, only the federal government provides funds for the period between 1994 and 2004; it can be expected that these transfers will be continued after that period. In 2003, in view of its financial distress, Berlin asked the Constitutional Court for a similar solution. This trend shows that states in financial distress can count on being bailed out. It also implies that the financial markets can serve as a controlling mechanism only in a very limited way.

It should be noted that the German system of fiscal federalism also widely uses the instrument of mixed-financing where the federal layer and the Länder finance projects together, as a general rule, on a half and half basis. For example, Article 91a of the German Constitution designates mixed-financing to support the specific joint-projects (Gemeinschaftsaufgaben) of renovation and expansion in university construction, improvement in regional economic structure and improvement in agricultural structure and coastal protection. A total of 3.0 bill euro was dedicated to such projects in 2002. Other collaborations of the federal layer and the Länder that come under mixed-financing include the

12 Compare the proposal of the German Council of Economic Advisers ( 2001: 132 on). 34

promotion of research and development (3.2 bill euro), social housing construction (0.7 bill euro), regional transportation improvements (1.5 bill euro) and city construction and development (0.4 bill euro). Although mixed financing has intensified in the last three decades, it is now common opinion that this type of financing should be reduced in order to obtain a clearer assignment of responsibilities. In addition, the institutional set-up for the voting procedure in many areas where both the Bundestag and the Bundesrat have to agree, comes under discussion.

Moreover, it should be noted that flows between the regions also take place in the social security systems. Thus, labor market districts with high unemployment receive funds to pay the insurance benefits from areas in which the unemployment rate is low, but where greater contributions to the insurance are paid. Similarly, in the other branches of the pay-as-you go systems of social security, the regions with a strong economic activity pay in whereas the regions with a lower performance receive funds. Unfortunately, there is not sufficient information on these flows.

The Strategy of Fiscal Policy: Demand Side versus Supply Side Approach

In Germany’s fiscal policy, traditionally the debate between the two concepts of the demand side versus the supply side approach tend to pop up quite regularly.

This discussion has several aspects relating to the business cycle, to growth and to the philosophical position with respect to the relevance of the demand versus the supply side for economic policy.

Recessions are characterized by a lack of aggregate demand. It is now common opinion that one should let the automatic stabilizers operate and that one should 35 accept that thereby a budget deficit arises or increases. But there is a cap placed on the budget deficit by the stability pact motivated by defending the stability of money. Those who favor aggregate demand as an important policy variable do not accept this restraint; they are not as concerned with the impact of debt on the stability of money. Quite a few, among them the trade unions, request that the government explicitly expands aggregate demand in addition to letting the automatic stabilizers play. They put a large weight on the demand stimulus, directly associated with government spending. This group is a minority among German economists, including the Deutsche Institut für Wirtschaftsforschung in Berlin with a strong leaning towards demand policy. The majority of German economists, among them the Kiel Institute for World Economics and the Council of Economic Advisers, points to the long-run and the short-run effects of such a demand stimulus. First, it increases debt because the political process has not been able to balance the budget over the cycle. Institutional restraints simply are not sufficient to control the increase in debt. Thus, the demand stimulus comes at high costs, and it threatens the sustainability of public finances. Second, it is doubtful whether aggregate demand actually would be stimulated. Government demand accounts for only 20 per cent of aggregate demand. If consumers anticipate the long-run effects on debt and expect taxes to be raised in the future, for instance if they see unemployment rising, they would become uncertain about the future. Therefore they may tend to increase their savings, which in turn would reduce the most important part of aggregate demand, consumption. Likewise, entrepreneurs may become more cautious with their investment demand. These psychological effects become especially relevant, when market participants lose confidence, for instance, when a government uses budget deficits over and over again and when it is clear that politicians use deficits as a way out of a their political malaise.

36 From the point of view of growth policy, a short-term demand stimulus is an even more questionable concept since growth policy needs a long-run orientation. Whereas it is true that a growth process requires sufficient aggregate demand and that weakness of demand would curtail the growth rate, growth itself must come from the supply side, i. e. from an increase in the labor force, from capital accumulation, from technological innovations and institutional improvements. Moreover, in the long-run the issue of sustainability becomes more important.

German fiscal policy has some experience with demand stimulation. For example, the high growth rates of 1990 and 1991 were the result of a Keynesian demand stimulus, initiated by governmental transfers to East Germany, most of them consumptive. Distortions in the construction sector and the recession of 1993 were the consequences. Then finance minister Lafontaine, after some government restraint with respect to expenditures since 1992, used the policy of demand stimulus expanding the expenditures of the federal layer by about four per cent in an approach similar to the first two years of the Mitterand presidency in France. He failed after half a year because the negative impact became apparent quickly.

The Erosion of Confidence

It seems to be an iron-clad law, that during their term in office finance ministers experience an erosion of their reputation with a loss of public confidence. Most of them start out with a strict consolidation plan and a clear determination to keep their budget in balance so that debt does not increase. Only a few can live up to their promise. Among them were Schäffer, who accumulated public funds in the 1950s (it is said in preparation for being able to pay for the Bundeswehr 37 when it was established), and Stoltenberg, who reduced the budget deficit in the 1980s. For most of the others, new and unexpected political problems arose that required additional financing, as in a recession for example; or the government had to win an important election and therefore increased spending; or their Chancellor simply changed his line of politics. More recently, fiscal policy has had to step in when the social security systems run out of finances (see below).

When Eichel took over the position of finance minister from Lafontaine in the spring of 1999 he announced a strategy of consolidation. Instead of Lafontaine’s philosophy of aggregate spending, Eichel promised to consolidate the budget.

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