October 05, 2018 | by FRIEDRICH HEINEMANN
Everyone's keen to spend, as long as they don't foot the bill. A lack of tax autonomy in Germany's federal system means that better-off states are vying to spend more.
The upcoming Bavarian election is a telling case study about German financial federalism. Ahead of the regional ballot on October 18, politicians from across the political spectrum are trying to outdo each other with the best ideas for spending money. From building theaters to new fiber optic cables, creating more social housing, free children's day-care and even free public transport, political parties' election programs are brimming with ideas for new state-funded services. Often they only differ when it comes to their priorities: While the Christian Social Union (CSU) emphasizes security by pledging to beef up Bavaria's border police, the Social Democratic Party (SPD) program obviously favors social spending while the Green party pushes its environmental goals. What is common to the party programs is that they hardly mention any finance-generating plans – and if they do, they are brief and vague.
This competition to have the best money-spending ideas is typical of German state election campaigns and it is completely rational from the state parties' perspective. The bottom line is that federal states in Germany cannot set their own taxes to any meaningful extent. That is different among U.S. states or
Swiss cantons, where politicians can set the income tax rates for their respective populations. But Germany, from Schleswig-Holstein to Bavaria, has uniform taxation rates in key categories such as income tax, value-added tax, corporation tax and inheritance tax. As a result, regardless how much extra spending is approved by the parliament in Munich in the future, taxes in Bavaria will not rise faster than elsewhere in the country. Any possible financing problems will be counteracted by the national approach to financing, the so-called fiscal equalization system, whereby the less well off states are supported by wealthier ones.
Tax cut pledges don't sway voters
Bavaria has long been the most important player in this system whereby states all pay into the same pot, supporting those who need it to stay financially stable. This fact lies behind Bavaria's enthusiasm to spend. The prevailing attitude is: If Bavaria has to pay for public services elsewhere in the republic through the states' financial arrangement, then it should ensure it also profits from better state services.
This “now it's my turn” mentality reflects the lack of tax autonomy in Germany. If Bavaria had the power to reduce income tax for its own citizens, then a political party could also score points with voters by promising tax cuts. As it stands, however, there is a disastrous asymmetry: federal states have many ways to give their voters money via spending, but they have no way to relieve their taxpayers by slashing taxes. This, in turn, fuels a political competition in which public spending only moves in one direction: upwards.
The last country report from Bertelsmann Stiftung's Sustainable Governance Indicators (SGI) shows that Germany is generally in a very good position in terms of the sustainability of its public debt. By contrast, it makes a less favorable assessment of German tax policy, which has been passive for too long. In the context of the members of the Organization for Economic Cooperation and Development (OECD), Germany's competitiveness in the sphere of corporate taxation is currently being eroded by extensive tax reform in other industrialized countries, especially the U.S. The Centre for European Economic Research has compared the effective tax burden of companies and has showed that in the European Union in 2017, only France taxed its companies more heavily than Germany. In addition, there are very high taxes for average earners that stifle productivity. This is due to high social security contributions as well as rapidly rising marginal tax rates in income tax. German politicians' inability to significantly lower tax rates despite a huge increase in tax collected is the consequence of the state level competition to spend as much as possible, now on view in Bavaria. If every extra bit of high tax revenue gets used up in this ongoing competition, there can be no significant tax cuts in Germany as a whole.
Federalism will be abolished
In 2017, the federal and state governments have even decided to further dent the financial autonomy of federal states by reforming the fiscal equalization system between the states. From 2020, the existing horizontal fiscal equalization (with state-to-state transfers) will no longer exist, and financial differences between states will be entirely offset by vertical transfers from the federal government. As a result, the federal states are increasingly becoming dependent on the federal government, as opposed to retaining financial responsibility. In terms of fiscal policy, the next decade essentially marks the departure from federalism in the German Federal Republic.
Instead, states like Bavaria should finally opt for more tax autonomy. Only when states have a significant say in setting their tax rates will people voting in state elections remember that they do not only get benefit from spending, but they also pay taxes. And only then would it be possible to make a balanced assessment of the electoral pledges. New theaters or free local public transport may be appealing to voters in Bavaria if people assume they fall from the "federal sky". However, if these additional services simultaneously push up taxes in Bavaria, then more careful costs-benefits checks are likely.
Early signs of increasing autonomy
A promising starting point is the current debate underway among the grand coalition government in Berlin on the future of the solidarity surcharge (payments from western Germany to former East German states following reunification). These payments could be turned into a state surcharge on income tax, which is initially charged in full as before, but which states could set for themselves in the future. The proceeds from the solidarity surcharge would then be at the disposal of states. This type of new state autonomy in updating of the solidarity payments would create completely new incentives. In the next regional election campaign, parties could promise a rapid reduction in solidarity surcharges instead of new spending programs. Voters could then finally opt for a higher or lower state budget with a correspondingly higher or lower tax surcharge.
The Free State of Bavaria, as it is officially known, is a self-confident state that takes its own stance on issues, including border security. For the sake of German federalism it is to be hoped that Bavaria will finally start seeking new state powers, which really make sense.
Friedrich Heinemann is Head of the Research Department Corporate Taxation and Public Finance at the Center for European Economic Research in Mannheim and Associate Professor of Economics at the Ruprecht-Karls University in Heidelberg. He is co-author of the SGI Country Report Germany of the Bertelsmann Stiftung.