The literature has identified various potential effects of this generous equalization system, including: first, strong reliance on transfers may encourage Länder to spend without due consideration for debt sustainability (the so-called ‘soft budget constraint’); second, dependence on transfers to finance spending may result in pro-cyclical spending, especially in good times.
The paper confirms that reliance on transfers weakens fiscal discipline. Fiscal reaction functions for a panel of the ‘old’ Länder between 1985 and 2007 are estimated, relating different budget items to an output gap and the lagged deficit. Results show that net-recipient Länder (i.e. states that are benefactors of the equalization system) have not reduced primary expenditure significantly in response to rising deficits. Instead they have relied on vertical transfers from the central government to ensure debt sustainability. Moreover, these Länder have pursued pro-cyclical policies, particularly by raising expenditures in good times. Net-contributing Länder, in contrast, have ensured fiscal sustainability through spending adjustments and been less pro-cyclical. To explore the dynamic responses to shocks, a panel vector autoregression is estimated. The results confirm the earlier findings, suggesting that the observed fiscal indiscipline in net recipient Länder is due to the expectation of receiving substantial vertical transfers to finance increased expenditure.
These results highlight the need for several reforms: (a) increased autonomy for local taxes to increase accountability and incentives for revenue collection; (b) a review of vertical (federal) transfers; and (c) expenditure-based fiscal rules at the state level to strengthen fiscal discipline. Although each measure is likely to face opposition by a number of states, fiscal federalism reform is needed to create appropriate incentives for fiscal responsibility at the state level.