Fiscal incentives in fiscal federalism: Analysis of Germany's fiscal equalization scheme

While the so-called “First Generation of Fiscal Federalism Theory” (e.g. Oates 2005) focusses on the advantages and disadvantages of decentralization considering economic externalities under the assumption of benevolent welfare-enhancing governments, the so-called “Second Generation of Fiscal Federalism Theory” takes into account benefit-maximizing governments as well as “Leviathan” governments. However, in decentralized multilevel systems, autonomous public-administrative decision-makers are influenced by fiscal incentives which depend on the fiscal institutional settings of the multilevel system. Therefore, the impacts of the specific federal fiscal arrangements to assign competences and allocate outcomes is crucial for reaching economic goals.

The present paper analyses the implications of Germany´s fiscal equalization scheme. Thereby, the work addresses the issue of fiscal competition within a multilevel system with strong fiscal equalization.  The first part focusses on the literature on fiscal incentives in federal systems and identifies the common assumptions. Our findings point out that a rather neglected issue is the consideration of the effects of different “marginal tax rates” caused by differences in population size of jurisdictions on convergence or divergence of regional development. We discuss theoretically the consequences of fiscal equalization systems where per capita equalization dominates. We show that in the case of jurisdictions which are differ in population fiscal equalization can distort the spatial capital allocation with crucial effects on regional growth of GDP and tax revenue, which influences the capability for regional public-administrative decision-makers supporting the regional economy in a fiscal competition. We provide a brief overview on the institutional background of the current German fiscal equalization scheme.  First we describe the dataset and estimation strategy to analyse the determinants for regional growth in GDP as well as tax revenue. We use official annual data for the 16 German states for the years 2005 (starting point of a “new” fiscal equalization scheme) up to 2014 provided by the Federal Statistical Office and the Federal Ministry of Finance. We discuss recommendations for fiscal federalism reforms to avoid differences in treatment between sublevel jurisdictions in a fiscal competition in multilevel systems.