The Price of German Federalism

Sixteen state governments and parliaments, the same number of administrative systems, and, for example, different terms of summer holidays. That is, in short, the essence of the German federalism. Generally speaking, this model, which is one of the main features of the German political system, is viewed very positively. It is in line with historical tradition when in the past centuries there had been an absence of a strong central government. But, at the same time, it guarantees mitigation of various regional differences with the help of assorted rules and mechanisms.

The most famous among them is the so called “Landerfinanzausgleich” [balancing of states’ finances]. Put simply, more affluent regions subsidize regions less well off, for example of former East Germany. Only last year nine billion euros were redistributed among the sixteen federal states.

The whole system has been working since 1969 and has been updated several times. It has become a complicated mechanism indeed, with the first paragraph of the law longer than one standardized A4 page. There is a joke shared among the German experts at finance law: at the whole Ministry of Finance there is only one clerk who knows his way through the maze of regulations regarding the cash flows among the federal government and individual states. Unfortunately, no one can locate his office.

Levelling of differences among the individual states takes place on many levels. First, the yield from income tax is redistributed. From each thus obtained euro, 0.425 euro goes to federal coffers and to budgets of respective states. The remaining 0.15 euro goes to municipalities. At the next stage, up to 75% of sales tax yield goes to weaker states so they approach the median. And at the last stage the real differences are being tackled, when the real financial situation of any given region is taken into an account—costs of state administration, population density or number of citizens receiving social benefits. So a state in the union whose financial strength is at 70 percent of the median gets boost and reaches 97.5 percent of the average. And on the other hand, a state which takes in 130 percent of average ends up with 109 percent after all the dust settles.

The goal is that all parts of Germany provide equal conditions for life. That is the theory at least. Real life situations do differ substantially. The strongest critical voice comes from municipalities; the job at hand is only getting bigger and bigger, yet their budgets do not see any positive development. Bertelsmann foundation notes that 25 percent of municipalities is balancing on the brink of default. Its study was conducted before the current migration crisis—we can only imagine the state of communal budgets now, when they are the ones bearing the brunt of the immigrant wave.

Another trend is apparent as well. Despite the financial transfers, which have been only getting bigger and bigger, the differences among the states remain. The disparity seems to be even growing, thus economically strong regions are getting richer and poor are getting poorer.

And that seems to be a thorn in the flesh of regions that are among the net contributors, in other words, the states that send more to the coffers then they receive: Bavaria, Baden-Württemberg, Hessen, and Hamburg. An odd case is North Rhine-Westphalia, which for many years had been a net contributor but in 2010 ended up on the receiving end.

The biggest lump paid into the redistribution fund is sent by Bavaria, which just last year contributed over half from the total of 9 billion euros. Its share is growing almost every year. In 1995 it was 1.3 billion and in 2011 it was almost 5 billion. The biggest net receiver is on the other hand the capital Berlin, which only last year obtained 3.5 billion euros; one seventh of the total budget.

Net contributors have been criticizing the system for a number of years; the main argument being that the differences are levelled way too much and the successful are being punished. After all the transfers are accomplished they are left with only a little bit more than the poorest performers.

With that there is an added accusation of administrative incompetence and costly out-of-reality projects such as free preschool or tertiary education.

All this led Bavaria and Hessen to file a constitutional complaint against the current redistribution model. They claim it is no longer viable for three strong economic performers to subsidize the remaining thirteen.

At the same time there have been negotiations between the states and the federal finance ministry that should lead to a new agreement about cash transfers among the regions. And there is not much time left.

In 2019 the present system is due to end, along with the so-called pact of solidarity, which has guaranteed financial help to the new federal countries of the former East Germany. If new solution is not found by then, it will lead to tangible budget cuts.

And to make the matters even more complicated, in 2020 a new law comes into effect, establishing the so-called debt brake, which outlaws deficit budgets of individual states, thus in effect enforcing balanced budgets across the board. That is the reason for the feverish pace of negotiations, with regional governments trying to grab the best possible deal. So much so, that one cannot make out who wants what. The fault line thus goes through the whole of Germany: north against south, former West against former East, city states against sparsely populated rural areas.

German finance minister Wolfgang Schäuble made a promise to subsidize the states with an annual sum 8.5 billion euro after the year 2020; it is quite possible that in order to reach an agreement he might be persuaded to raise it. He does not want to sell himself cheaply though. In exchange for federal funds he is asking for a greater degree of supervision over state budgets and their compliance with the debt brake. As of today, there are four states under federal supervision as they have been struggling with dramatic deficits: Bremen, Berlin, Saarland, and Schleswig-Holstein.

What is at stake are not only cash flows among the regions but the federal system of Germany as such.

Its reform has been discussed since the beginning of the Federal Republic of Germany. The problem is that few of the regions are willing to give up their sovereignty freely. Not only is the local patriotism at play, but political interests of their elected representatives as well.

Manfred Stolpe, veteran premier of Brandenburg, has fanned a new discussion. This summer he suggested the creation of a new East German super state—the union of Berlin, Brandenburg, Sachsen-Anhalt, and Mecklenburg-Vorpommern. It would be the largest state and the fourth most populous. These parameters would ensure a corresponding influence on the federal level. The lack thereof is an often mentioned ill that current East German politicians complain about.

The possibility of a union of East German states is real for another reason as well. The regional awareness there is not as strongly developed as in the German West. The obvious explanation would be that during the existence of communist Eastern Germany the historical states were abolished. They were established again after the reunification of Germany in 1990. Exceptions are to be found though; in 1996 there were elections about the proposed unification of Berlin and Brandenburg, and voters said no. One of the possible explanations might be the worries of rural oriented Brandenburg of joining with the debt-ridden metropolis.

In the western parts of Germany similar thoughts were almost unimaginable, and that is why, with one exception, fusions were out of the question. In 1952 voters did decide in referendum about the establishment of Baden-Wurttenberg. Up to now even the regions struggling with economic problems and high levels of debt have been resisting the idea of fusion with others. Some of them are able to function only because they obtain almost all of the funds necessary for their administration via redistribution. Take Bremen, for example. This city state with little over 600,000 inhabitants has to follow a rigid austerity program. Its debts amount to 20 billion euros and due to austerity cuts in the past years the city now struggles with the lack of police personnel, teachers, or hospital staff. Saarland also belongs to one of the most indebted regions as it is struggling with expensive programs to compensate for black coal mining and steel making industries which are being driven down. Hence the speculations that Saarland and Bremen might become parts of bigger entities. Saarland might join Rhineland- Palatinate and Bremen along with Schleswig-Holstein might create new north German state.

There have been voices of opposition as well. Fusions of federal states will not lead to lessening of their economic woes, they say, even if the savings in administrative costs are evident. The main problem purportedly lies in the financing of municipalities and eventual fusion of federal states shall have no bearing on their financial status; unless they get a higher cut of their income or sales taxes, their situation is bound to remain dire.

There is another model being put forward by economically strong regions led by Bavaria. Its essence would be a tax autonomy for individual states and lesser degree of redistribution on the federal level. Regions would have the possibility to reduce corporate taxes by few points and thus attempt to lure in potential investors. This is the model applied by Switzerland or by the United States and if such measures were to be adopted by Germany, which is not very likely at this point, the very essence of German federalism would be changed—it would no longer be the system of cooperative federalism which strives to mitigate differences but a federalism of competitive nature.

Europeans should not ignore the current debate concerning the German finance redistribution. It offers an interesting insight into the inner structure of a federally organized community, which has an ambition to apply some of these mechanisms on a pan-European level. The issues of tax harmonization, common tax base, oversight over member states budgets, or currently a fixed quota of migrant distribution among European states—that all has its roots in the German federal system.