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The German Constitutional Court takes on the principle of ‘solidarity’ BY PAUL BERND SPAHN little more than two years ago three This conflict on equalization is effectively federal government (vertical fiscal Southern states (Baden-Württemberg, Bavaria, and Hessen) launched a constitutional challenge to the system of intergovernmental fiscal arrangements in Germany. Their quarrel with the system of interstate equalization was that it redistributes wealth to an excessive degree and creates negative incentives. In its ruling of November 11, 1999 the German Constitutional Court declared the equalization law to be “transitory”, and ruled that it should be phased out as of the 1st of January 2005. The Court’s verdict has given some support to an in-depth revision of the general philosophy of the German Constitution, and spurred fartherreaching discussions of intergovernmental fiscal relations. a dispute over how far Germany should go to practice what Europeans call “interregional solidarity”. Can this “solidarity” be promoted without generating negative incentive effects? The Court did not answer this question but took a formal approach to the technical aspects of the intergovernmental fiscal machinery. Mechanisms for sharing the wealth in the German federation In order to assess the Court’s ruling, it is essential to have a basic understanding of intergovernmental fiscal relations in Germany (see box below). Considering that income taxes are shared among tiers in fixed proportions, a balance between the states and the balance) is mainly achieved by varying the states’ share of the value-added tax. This is based on federal legislation, with the cooperation of states through the Bundesrat (the second chamber of the German parliament, consisting of appointed representatives of the state governments). On the basis of an assumed fiscal balance among tiers of government, horizontal fiscal balance among states is then realized in three steps: the regional apportionment of the value-added tax; an interregional redistribution scheme; asymmetrical federal grants. The Constitutional Court found that there is a lack of clear criteria for defining how wealth should be redistributed between jurisdictions. And it requested greater transparency for fiscal equalization, both among the states and between the states and the federal government. Vertical equalization Regarding the sharing of resources between the federal level and the states, the constitution demands a definition of “necessary expenditures” at each level of government, and a “fair compensation” among jurisdictions. The Court deems this to be possible on the basis of objective statistical data and medium-term planning. Unfortunately, this is likely to be an illusion. It is impossible to compare the necessity of national defense at the federal level with education at the state level without relying on value judgments. Objective “needs criteria” are more easily established among entities with comparable responsibilities at subnational levels. It is perfectly feasible, for instance, to identify norms to allocate resources among states for primary education (e.g., the number of children of school age, and student-teacher ratios). In a first reaction (of September 2000) to the ruling of the Court, the federal government has proposed to base the sharing of the value-added tax on the actual budget and financial planning exercise, in which the states are involved regularly. Moreover, the Finance Ministry regards a “law on general standards” redundant for that purpose. The existing machinery of value-added tax sharing would generate similar coverage ratios between “current income” and “necessary expenditure” at each level. It would also ensure fair compensation. However, the Ministry considers an automatic rebalancing mechanism for the value-added tax share to be useful. But it is unclear how criteria for managing such a mechanism would be determined. Horizontal equalization among the states The mainstay of the Court’s verdict is on equalization among the states. The German Constitution obliges lawmakers to take measures to equalize the differences in the financial capacity of states. This refers to actual financial resources, not to a relationship between revenue and specific expenditure needs. The Constitution defines a yardstick for equalization between the states by the number of inhabitants. The Court, in its decision, criticized the existing practice of weighting of population as a method to express specific burdens in certain cases—such as in the case of city states. The Court requested a scientific procedure of balancing, based on accurate data. But neither the federal government nor the states have seen the need to act. Moreover, the Court questioned elements of “specific burdens” (for instance of harbours) that have crept into the state-tostate equalization system. The Court said they should either be abolished, or applied more generally on the basis of solid statistical criteria. The Court points to a clear constitutional dilemma here. On the one hand, the Constitution requests an objective quantitative approach for resource sharing between the federation and the states. (And it should be noted many experts argue such an “objective” approach may be, in fact, unattainable). On the other hand, it says that population is the sole criterion for distributing resources among the states (whereas an approach based on needs could, in principle, be possible). Given the German tradition, however, it is unlikely that more specific criteria for needs (as in Australia) will be used in the future. The federal government is indeed prepared to abolish “needs related” elements in its equalization formula—such as the provision for harbours. However, it wants to retain the weighting in favour of city-states, arguing that there are peculiarities to be considered in the formula. Such peculiarities would be based on more reliable and objective criteria in the future. Moreover, the Court wants “financial capacity”—the sole distribution criterion for equalization among the states—to be understood in a comprehensive way. Not only tax revenue, but also other non-market income of jurisdictions (such as royalties and concession levies) would have to be taken into account. Also municipal financial resources (now counted as elements of the states’ financial capacity by only 50 percent) would have to be included in full. The federal government seems to accept the Court’s request to calculate the financial ability of states in a comprehensive sense. But the reaction of the paying states remains to be seen. Some—in particular the richer “challengers”—would likely lose resources if this were done. Federal intervention The Court was particularly critical of federal equalizing grants. It stated clearly that federal grants must remain exceptional and transitory measures to mitigate the financial stress of particular states. At present, federal grants have a strong equalization effect on fiscal capacity per capita (99.5 percent of the state average for all states). They even have perverse effects— in that poorer states may end up at higher capacity levels than the richest ones. The Court seems to have limited the degree of per-capita equalization to a level of 95 percent of the average. The federal government will therefore have to reduce the number of its grants as well as their magnitude. In a first reaction, the Federal Finance Ministry has indeed announced that federal grants for relieving the costs of political management would no longer be made. States in a situation of budgetary distress would still receive grants in the future, but only for a limited time—and on a regressive scale. States that are to receive such grants will have to present binding plans for financial reorganization. The federal government and the states will share the burden of such grants in relation to their spending. Overall, the ruling of the German Constitutional Court will require a fundamental review of the existing German equalization law. But German lawmakers are unlikely to allow the existing model to disappear completely. Rather they will likely try to limit the changes, as much as possible, to minor revisions. In the Germany of the new millennium interregional solidarity—the notion that there must be as great a measure of economic equality in the federation as possible— continues to exert a strong hold on the political culture, notwithstanding the stresses of unification. Federations volume 1, number 1, march 2001