In the state financial equalization, municipal taxes are considered 75 percent of the states’ financial strength. The partial credit disadvantages countries with below-average local tax capacity. The federal supplementary allocations for disproportionate local tax capacity do not compensate for this effect, but in turn cause unsystematic compensatory effects. The article explains the extent of the distortions and presents a reform option.
The aim of the state financial equalization is primarily to bring about a more even level of financial resources for the states relative to their financial needs. With this goal, three instruments have been used since 2020: (1) the sales tax equalization among the states, (2) the general federal supplementary allocations and (3) the federal supplementary allocations for disproportionate local tax capacity.
Divergent standards of financial equalization
Sales tax equalization and general federal supplementary allocations are based on uniform financial strength and financial needs indicators. The system is based on financial strength metrics, which include 75 percent of not only the states’ tax revenues but also those of their municipalities. To determine the compensation claims and compensation obligations, the financial strength metrics are related to the respective population-weighted needs or compensation metrics. 1)
The municipal tax force allocations follow a completely different logic. If a country’s municipal tax capacity falls below 80 percent of the country average, the difference to this value is offset by 53.5 percent. The relative municipal tax capacity as a benchmark for compensation does not correspond to the basic system of state financial equalization. It is therefore not surprising that the municipal tax power allocations produce (presumably unconstitutional) over-levelling effects, i.e. the recipient countries can overtake other countries with previously higher financial power (Scherf 2023).
Distorting calculation of municipal tax capacity
In fact, the municipal tax allocations are an unsystematic concession to the East German states for their special needs allocations that expired in 2019. However, that does not mean that a relatively low municipal tax capacity cannot justify a special need for compensation. While below-average state tax capacity is fully included in the financial strength measure, below-average municipal tax capacity is only reflected at 75 percent. Table 1 shows that this results in distortions in the state financial equalization.
The three countries considered A, B and C have the same overall tax capacity or financial capacity (FK) at 6,000 euros per inhabitant. However, the municipal tax capacity (SKG) is above the average of 1,680 euros per inhabitant in country A and below the average in country C, while country B exactly reaches this value. Conversely, country tax capacity is below average in country A and above average in country B. 2) As a result of the partial crediting of municipal taxes, the financial strength index (FMZ) of all states falls short of their actual financial strength, but to varying degrees. The relationship between the financial strength indicator and the financial strength (FMZ/FK) is determined by the share of the municipal tax strength in the financial strength (SKG/FK).
The financial strength measure determines whether a country is a net contributor or net recipient. In the present case, all countries are financially strong on average and should therefore neither receive compensation payments nor pay compensation contributions. However, because of the different tax structure, country A has a below-average financial strength measure and country C has an above-average financial strength measure. As a result, country A becomes a net recipient and country C becomes a net contributor. As a result, the partial recognition of local tax capacity discriminates against countries with a below-average share of local tax capacity and privileges countries with an above-average share of local tax capacity in financial capacity.
Structurally neutral partial crediting of tax capacity
The structural issue of unequal treatment of state and local taxes can be solved in various ways. First of all, full consideration of municipal tax capacity instead of only partial consideration would be considered. However, broadening the assessment basis would increase the compensation volume and the border burdens in the state financial equalization (Scherf 2020) increase significantly. It would therefore have to be accompanied by a countervailing reduction in compensation rates.
Structural neutrality could also be achieved through a small modification to the tax credit calculation. Instead of the asymmetrical inclusion of state and local taxes at 100 and 75 percent, respectively, the total tax capacity could be calculated with a uniform reduced inclusion rate equal to the average FMZ-FK ratio of 0.93. In Table 1, the financial strength metrics of the countries (FMZ 2) calculated using this method agree again and correctly signal that all countries have the same financial strength. 3)
The correction method outlined can easily be applied to the 2022 state financial equalization. Figure 1 shows the changes in the sales tax equalization (USt) and the general federal supplementary allocations (a BEZ), which result from structurally neutral accounting of state and local taxes compared to the current system. 4) This correction would benefit, among other things, all states that currently receive supplementary federal allocations due to their below-average local tax capacity (BB, SN, MV, TH, ST, SL).
Overcompensation through municipal tax allocations
Against this background, one could come up with the idea that the municipal tax capacity allocations have a hidden function in the state financial equalization, namely to compensate for the disproportionate crediting of the municipal tax capacity. But this is not the case. Rather, the allocations of municipal tax capacity actually result in massive overcompensation for the effects of below-average municipal tax capacity. For comparison, the green columns in Figure 2 show the additional relief for recipients of municipal tax allocations (g BEZ) that goes beyond compensating for structural disadvantage. In today’s system, they receive a significant, unfounded special discount.
If one had wanted to correct the distorting effects of the partial crediting of municipal taxes during the reform of the state financial equalization from 2020, then the approach outlined here of a structurally neutral calculation of the financial strength metrics would have been the adequate solution. With the introduction of municipal tax allocations, which do not follow the system logic, a much worse distortion of the state financial equalization has occurred.
It is by no means impossible that the Federal Constitutional Court will object to the allocation of municipal tax capacity in the event of a lawsuit against the current state financial equalization system. The legislature could then resort to the option proposed here of symmetrically reduced crediting of state and municipal tax capacity in order to cushion the loss of municipal tax capacity allocations and at the same time improve the system of equalization of financial capacity.
Remarks
1) The percentage population weights for state taxes are 100 for the territorial states and 135 for the city states. In principle, the same values apply to municipal taxes, with the exception of three regional states that receive increased population weights: Saxony-Anhalt 102, Brandenburg 103 and Mecklenburg-Western Pomerania 105.
2) The values in Table 1 are chosen to be realistic. In 2022, the following average values per resident resulted: SKL = 4,264, SKG = 1,554, FK = 5,818, FMZ = 5,429, SKG/FK = 0.267, FMZ/FK = 0.933.
3) Both methods reduce the effective compensation rate. The formal compensation rate, for example in sales tax compensation, is 63 percent. In today’s system, the effective compensation rate based on the municipal tax capacity is 0.75 x 63 = 47.25 percent. In the model in Table 1, the same effective equalization rate for state and local taxes is 0.93 x 63 = 58.59 percent. When it comes to sales tax distribution, the structurally neutral model leads to the same results as full crediting of the entire tax burden with a corresponding reduction in the compensation rate.
4) The calculation is carried out under the condition of revenue neutrality. Taking into account the slight increase in general federal supplementary allocations, the loss of municipal tax allocations will be compensated for by an increase in the states’ share of sales tax.
Justus-Liebig university of Giessen