The spatial and economic impact of fiscal equalization in Germany

Fiscal transfers in the spatial economy

Many countries conduct spatial development policies targeted at economically lagging regions within their territory. Place-based policies often take the form of discretionary spending by higher-order government layers, such as the federal level, to subsidize investment or job creation in designated recipient areas. Examples include enterprise zones in the United States or structural funds in the European Union. But those regional policies are just one possible instrument how governments can affect the spatial economy. An equally, if not more, important mechanism is fiscal equalization. This policy redistributes tax revenue from areas with high financial capacity to poorer jurisdictions and thus effectively allows recipient regions to offer more public goods than they otherwise could.

A recent study published in the American Economic Journal: Economic Policy—by Marcel Henkel, Tobias Seidel, and Jens Suedekum—investigates this issue empirically, based on data for the Federal Republic of Germany. The authors estimate that a remarkable total volume of €53.5 billion worth of transfers is shifted across jurisdictions every year. This includes the federal fiscal equalization scheme, which allocates tax revenue between the 16 states and the federal level (Länderfinanzausgleich); several lower-tier schemes that provide additional equalization across municipalities within states; and various discretionary grants from higher- to lower-level government layers. The amount of fiscal transfers within Germany is thus more than twice as large as all EU structural funds taken together, and it dwarfs the amount that is paid on classical development policies by the German federal government.

Despite this prevalence of fiscal transfers, surprisingly little is known about their implications. How do they affect aggregate economic activity and the distribution of population and income across space? How do they shape regional migration flows? What is their impact on productivity and welfare at the national level?

To shed light on those questions, the authors set up and quantify a general equilibrium model with multiple asymmetric regions, labor mobility, costly interregional trade, and interjurisdictional fiscal transfers. They calibrate the model, taking into account taxes and transfers as observed in (or recovered from) the data. In a counterfactual analysis, the authors then simulate how the equilibrium would change if Germany were to abandon all transfers completely. In that scenario, local public goods are financed solely by taxing local economic activity. Comparing this counterfactual to the actual equilibrium allows the study to assess how, and through which channels, fiscal equalization affects the spatial economy. Afterward, the study also explores optimal transfers and compare this hypothetical ideal to the currently implemented German equalization scheme.

A quantitative approach is needed because the welfare implications of fiscal transfers are not clear-cut from a purely theoretical point of view. On the one hand, by shifting resources from rich to poor places, transfers may distort incentives and induce some workers or firms to locate in regions that they otherwise would not have chosen. These misallocations may be particularly severe when recipient areas have low levels of productivity or when they are remotely located so that transport losses in interregional trade are exacerbated. Fiscal transfers may therefore reduce aggregate output at the national level because they divert economic activity away from core cities.

On the other hand, the spatial economy might be affected by various externalities that individuals do not take into account when making location decisions. For instance, individuals ignore their impact on others that is transmitted via different agglomeration and congestion forces. A laissez-faire equilibrium without transfers may be characterized by an inefficient spatial structure and in particular, by cities that are “too large” from a social point of view. By reducing over-congestion in cities, fiscal transfers may therefore actually mitigate rather than exacerbate misallocations. The authors consider some stylized examples of the model and show that welfare implications are indeed ambiguous. Transfers are detrimental in some constellations but beneficial in others.

The quantification is challenging because the detailed rules of the German equalization schemes are complicated and span over several governmental layers (federal, states, and local municipalities). No official statistics are available for net transfer rates of local jurisdictions. To construct empirical proxies, the authors exploit information on the volumes of generated taxes and available public funds at the local level in the year 2010. Their approach assigns taxes and expenditures to the 141 German labor market regions (Arbeitsmarktregionen), which are defined to minimize cross-regional commuting flows.

The transfers that are recovered from the available data sources account for fiscal equalization schemes within and between the Federal States as well as the allocation of public funds across government layers. The numbers suggest that the total volume of redistribution is substantial. It amounts to €53.5 billion per year, equal to 10.2 percent of aggregate tax revenue. Local labor markets comprising the largest and most productive cities are the biggest net contributors. Frankfurt comes out on top with a transfer rate of 13.3 percent of local gross domestic product (GDP), which is equivalent to €4,000 per inhabitant that is paid to other jurisdictions via fiscal transfers. The main recipients are poor and remote locations, often located in east Germany, which receive support of up to 23.1 percent of local GDP.

In the counterfactual scenario, where all fiscal transfers are abolished, the authors observe a major migration wave out of the former recipient and toward the former donor regions. In total, the research suggests that roughly 2.8 million people would change their local labor market in the transition to a new long-run spatial equilibrium. Some east German regions would lose almost one-quarter of their population, while big cities like Frankfurt or Munich would substantially grow. As the induced migration is from less to more productive regions, the analysis observes substantial gains in aggregate national output and productivity in the benchmark specification. Given the preferred set of parameters, the model suggests that abolishing transfers raises average labor productivity by 3.4 percent and real GDP per capita by 2 percent. By retaining economic activity in the periphery, fiscal transfers, therefore, limit productivity and income dispersion, but this comes at the cost of lower national output and productivity.

However, when turning to national welfare, the authors find a different pattern. With the preferred baseline specification, they find that welfare even mildly decreases by 0.07 percent when transfers are abolished. The reason is that the former donor regions are already over-congested in the initial equilibrium. When transfers are switched off, additional migration into those crowded cities is induced, and this makes congestion even worse. In that case, abolishing fiscal transfers increases national GDP but not welfare. In alternative parameter settings, the authors sometimes obtain productivity and welfare gains from shutting down transfers, highlighting the sensitivity of the results. But welfare gains are then consistently much smaller than productivity and output gains because they do take into account the important (and empirically relevant) congestion externalities.

Summing up, the baseline counterfactual suggests that having some fiscal transfers is better than having no transfers in terms of national welfare. This does not mean, however, that the current level of fiscal equalization in Germany is the best of what could be achieved. Indeed, when exploring the optimal transfer scheme (taking current taxes as given), the authors find that it implies somewhat less fiscal equalization across local labor markets and somewhat smaller transfers than what is currently observed. In other words, current fiscal transfers are better than no transfers, but still, the prevailing level of equalization may be too large from a national welfare point of view.

Read the full journal article in the American Economic Journal: Economic Policy:

Henkel, Marcel, Tobias Seidel, and Jens Suedekum. 2021. “Fiscal Transfers in the Spatial Economy.” American Economic Journal: Economic Policy, 13 (4): 433-68. DOI: 10.1257/pol.20180294