OVERVIEW OF FISCAL DECENTRALISATION

Germany is a federal state composed of 16 regions (Länder). State powers are primary exercised by the Länder, as stated in the German Constitution: “the exercise of state powers and the discharge of state functions is a matter for the Länder" unless otherwise specified by the Basic Law. The municipalities are part of the Länder under Basic Law. Overall there are 16 Länder, 295 Kreise and 11,118 Gemeinden. Most cities with more than 100,000 inhabitants, and several with less, have both county and municipal responsibilities.

The analysis in this factsheet considers Länder as the state government level and Kreise and Gemeinden as the Local government level. 

Legal acts governing fiscal decentralisation

The most important legal act which governs fiscal decentralisation is the Basic Law (Grundgesetz). During 2006 there was a reform of the Basic Law with the aim of reorganising the legislation and making clearer distinctions between the competencies of the Länder and the Federation. A second stage of reform took place in 2009, which addressed the system of intergovernmental finances. Numerous other acts are established by the Länder themselves, which have legislative powers.

As stated by the Basic Law (Art.70 BL), legislative powers are assigned to the Länder unless conferred on the Federation by the Basic Law itself.   Exclusive legislative powers of the Federation extend over foreign affairs and defence, citizenship issues, migration, customs and trade, federal railways, and postal and telecommunication services. Current legislative powers of the Federation and the Länder concern civil and criminal issues, public welfare, economic legislation, energy, commerce, banking and insurance, labour issues, social security, unemployment insurance, educational grants and the promotion of research, urban real estate matters, hospitals, roads, environmental protection, and regional planning. Areas of legislation that have remained under Länder competence include education policy, municipal law, police law and the construction of roads.

Municipalities have the right to regulate all local affairs under their responsibility, within the limits established by law. However, municipalities are not allowed to establish fiscal legislation by themselves. The general principle states that the division of spending responsibility among the Federation and Länder for a government task matches administrative responsibility. For municipalities, the executive powers are limited to localised services, such as water, gas, electricity, refuse collection and wastewater services.  In addition, local planning (roads, public spaces and land planning) also falls under their responsibility. Cultural and sport activities are run on a voluntary level by the municipalities, and other social and health responsibilities may also be delegated to the municipalities.  

Qualifying fiscal decentralisation

Germany has one of the highest levels of fiscal decentralisation in the EU. Due to the considerable responsibilities of the sub-national governments, 50% of the government expenditures were managed by the Länder (31%) and municipalities (19%) in 2018. The German system seeks to ensure that funding distribution and the executive responsibilities are clearly defined.

 
Source: authors’ elaboration on EUROSTAT data. For further details, see methodology.

The legislative powers of taxation and the distribution of tax revenue in Germany are precisely determined. The legislation is designed to ensure that the responsibilities of the different levels of government are financed by appropriate sources of revenues. The federal government has some exclusive legislative powers over customs duties (which are an EU own revenue) and fiscal monopolies. For other taxes, it has legislative powers when the revenues are collected in full part for federal activities or to finance fiscal equalisation transfers.
Rules for shared taxes between the federal government and the Länder are precisely determined by the Basic Law. Income tax revenue – reduced by a share for the municipalities - and corporation tax are shared equally. Additionally, 75% of VAT revenues are redistributed across the Länder to ensure a uniform standard of living across the country (Art.106 of the Basic Law).   

Fiscal equalisation mechanisms

The equalisation mechanism involving the Federation and the Länder in Germany is one of the strongest in Europe. The aim of the system is to guarantee each Land the means to cover its necessary expenditures and to ensure equivalent living conditions. The system involves three levels: primary horizontal equalisation between the Länder, secondary horizontal equalisation within the Länder, and finally vertical equalisation by supplementary federal grants.

At the first level a maximum of 25% of the Länder's share of VAT goes to those Länder with below average revenue from income tax, corporation tax and Länder tax. The second step further equalises fiscal capacity at the Länder level. In the third step, supplementary grants are provided by the Federation to those Länder with subpar fiscal capacity. Thanks to this system, the variance of fiscal capacity across the Länder is considerably reduced.

Within the Länder, a separate equalisation mechanism also affects municipalities. As between Bund and Länder, equalisation within the Länder is not only vertical but also horizontal, with wealthier municipalities having to contribute. 

LEVEL OF FISCAL DECENTRALISATION

The constitutional obligation for the Länder to execute state obligations explains their high level of revenue autonomy (82% in 2018), clearly above the EU average for this level of government (64% in 2018). Not surprisingly given the high revenue expenditure obligations, own revenue decentralisation (25% in 2018) and the composite ratio (37% in 2018) are higher than the EU averages (7% and 8% respectively). Concurrently, transfer dependency (19% in 2018) considerably lower than the EU average (36%). For municipalities, the level of autonomy is close to the European average (57% and 53% in 2018 respectively), but slightly lower in some indicators due to the importance of the Länder. In 2018, own revenue decentralisation was 11% compared to 13% at the EU level, the composite ratio at 14% compared to 16% at the EU level, and local level transfer dependency was at 43% compared to 48% at the EU level.

 
Source: authors’ elaboration on EUROSTAT data. For further details, see methodology.

As the chart below demonstrates, taxes at the Länder level are mostly not determined by the Länder. The revenues are split with the central government. For municipalities, the level of discretion is higher. 

Source: authors’ elaboration on OECD data. For further details, see methodology. 

Fiscal rules and borrowing capacity

During 2011, Germany introduced a constitutional rule on balancing structural budgets that is applicable to the Federation and the Länder. The principle states that the budgets of the Federation and the Länder must be balanced without revenues from credit. The Basic Law further establishes a notional control account for the Federation where deviations from the ceiling are recorded: debits on this account exceeding 1.5% of GDP have to be reduced. These credit constraints may be exceeded in case of natural catastrophe or an unusual emergency. Closely linked to the reform concerning the budget rule was the introduction of a Federation-wide early warning system to prevent emergency budgetary situations.

The Stability Council, which commenced its work in 2010, was set up for this purpose. As part of the implementation of the Fiscal Compact in Germany, the Stability Council was also charged with monitoring compliance with the upper limit on the general government structural deficit. An independent advisory board was set up to support the Stability Council in this monitoring task. Budget balancing rules have also been in place for the local governments; budget law generally obliges the municipalities to balance revenues and expenditure in their administrative and capital accounts, but does permit some borrowing for investment purposes. The municipal agencies of the Länder are responsible for monitoring municipalities' budgets. In case of non-compliance, they can impose sanctions.

There is some coordination in the medium-term budgetary planning of the Federation and the Länder. A medium-term financial plan is adopted with the federal budget each year and extends over the next three years. The plan includes projections for the main expenditures and revenues. The Stability Council considers the overall economic and fiscal conditions in existence at the time of the federal, Länder and local government budget and financial plans being drafted. The aim is to coordinate budgetary and financial planning among the different levels of government. The Stability Council may also issue recommendations for the purposes of budgetary and financial planning coordination. 

Deficit and debt at sub-national levels

Given the very high level of responsibility of the Länder, the debt level is significantly higher than in other EU countries. In 2015 it was at 21.5% of GDP. This figure has recently been falling, reaching 17.6% in 2018. The lending to borrowing ratio  has concurrently been rising slightly from a balanced ratio of 0 in 2014 to net lending at 0.3 in 2018. In the case of municipalities, the level of debt is 4.8% of GDP in 2018 with no significant problem in the lending balance. 

Source: authors’ elaboration on EUROSTAT data. For further details, see methodology. 

EXPENDITURE BY GOVERNMENT LEVEL AND BY POLICY AREA

Given the constitutional obligation of the Länder to exercise state powers and discharge state functions, it is not surprising that expenditures as a share of general government expenditures are very high in most categories. The notable exception is health, which is mostly a federal competence, and defence. The responsibilities over education (76% of government expenditures in 2017) and public order and safety (73% in 2017) are very extensive. Given the additional expenditures in the municipalities, it is clear that sub-national authorities have the main responsibility over education in particular, but also have significant responsibility over public safety and general public services.

 
Source: authors’ elaboration on EUROSTAT data. For further details, see methodology.

The distribution of expenditure within the Länder reveals education and general public services, as well as social protection, to be the most significant areas.

Municipalities

In terms of the share of total general government expenditure, municipalities have important roles to play in financing housing (66% in 2017), environmental protection (50% in 2017) and recreation, culture and religion (44% in 2017). Among municipal expenditures, financing social protection and general public services are the most significant.

Source: authors’ elaboration on EUROSTAT data. For further details, see methodology.