Efficient Revenue Sharing and Upper Level Governments: Theory and Application to Germany

Abstract

Die Discussion Papers dienen einer möglichst schnellen Verbreitung von neueren Forschungsarbeiten des ZEW. Die Beiträge liegen in alleiniger Verantwortung der Autoren und stellen nicht notwendigerweise die Meinung des ZEW dar.Discussion Papers are intended to make results of ZEW research promptly available to other economists in order to encourage discussion and suggestions for revisions. The authors are solely responsible for the contents which do not necessarily represent the opinion of the ZEW.Download this ZEW Discussion Paper from our ftp server:ftp://ftp.zew.de/pub/zew-docs/dp/dp06013.pdf Non-Technical SummaryMany countries display a substantial degree of taxing autonomy for local jurisdictions while at the same time being characterized by some redistributive grant systems which tend to internalize fiscal externalities arising from tax competition. While the existence of redistributive grant systems may explain why local governments in those countries make use of distortive taxes despite of tax competition, it is difficult to derive policy recommendations.The reason is that the welfare implications from tax competition and tax coordination strongly depend on the government objectives.Given this background the current paper explores the conditions under which redistributive grant systems will or will not achieve or raise efficiency in local finances. We consider a standard model of tax competition of local jurisdictions and introduce a system of redistributive grants executed at the state level. The basic model is then extended in order to allow for variations in the government objectives at the state level. The theoretical results suggest that attempts of upper level governments to extract fiscal resources from the local revenue sharing system will tend to undermine efficiency of local finances, and, possibly, even result in excessive equalization.The implications from our theoretical analysis are finally contrasted with the experience in Germany. Germany is a particularly interesting case to study in this respect as it combines municipal tax autonomy and substantial revenue sharing among municipalities supervised and enforced by the states (Länder). At the same time, some of the German states are in an increasingly difficult fiscal situation where the debt burden is rather high such that they may be tempted to induce local jurisdictions to increase taxing effort.Moreover, also the German system of fiscal federalism provides several incentives and disincentives for government policies at the state level which allows us to investigate whether, in fact, the response of state governments to changes in the policy constraints, say a reduction in the grants received at the level of states, includes an adjustment of the revenue sharing system among municipalities.Our empirical analysis of tax policy in Germany suggests that attempts of state governments to extract fiscal resources from the municipal revenue sharing system exert an upward pressure on tax rates. This raises doubts whether the state government shoul...

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“…My method is similar to those of Baretti et al (2002), Hauptmeier (2009), andBüttner et al (2011), but with a novel distinction that I include the case of the new system arrangements which took effective from 2005 onward.…”

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“…Buettner, Hauptmeier, and Schwager (2006) further explore the conditions under which local grant systems enforced by upper-level governments will enhance efficiency. In the context of the German federation where fiscal policies of all levels of state are strongly interlinked by multi-20 level fiscal equalization and the sharing of common taxes, the study points to excessive local taxation as a consequence of upper-level government attempts to extract fiscal resources.…”

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