Germany’s federalism and finances: Municipal mayhem

Date: 16/08/03

The cities are going bust, but they don't fancy the government's rescue plans

IT TOOK Gerhard Schröder and his left-of-centre government almost five years to realise that Germany needs a serious makeover. But now it seems things can't change fast enough. On August 13th his cabinet hammered out half a dozen pieces of legislation covering things from welfare to the labour market, from federal budget to municipal finances, and more.

Yet, as is apt to happen, quantity, expediency and speed come at the expense of quality and substance, making it all the more likely that some of these measures will be much watered down on their way through Germany's tortuous legislative process, or maybe abandoned entirely. That risk is especially great for a reform package supposed to boost revenues for Germany's 13,800 cities and towns, many of which are on the verge of bankruptcy.

Increased welfare payments, and new responsibilities imposed but not financed by the federal government, have shoved up municipal spending in recent years. Revenues, in contrast, have declined; in particular, a trading tax that generates a third of local tax receipts (as against 17% from property, a mainstay of local finance in many countries). So total municipal deficits, €6.7 billion in 2002, may hit €10 billion (over $11 billion) this year.

Essen, for example, a once mighty industrial city in the Ruhr, has made deep budget cuts in recent years, cutting the number of municipal employees by about 15%, and investment by 40%. Yet this year it expects to be €386m in the red - nearly €650 for each of its 600,000 people.

For years the federal government shut its eyes to the problem. At last, in early 2002, it asked a commission to look for a solution. Last month the commission offered one: merge welfare benefits, now locally financed, with unemployment aid - the hand-out after (paid-for) unemployment insurance runs out - into a single new federal benefit. That would especially help large cities. Second, and more important: widen the trading tax, which now mainly depends on profits, to hit rents, leasing fees and interest payments.

The government at first seemed ready to try, but then yielded to the arguments against forcing firms to pay taxes even when they are making losses. Instead, it decided to broaden the tax base, by ending the exemption of self-employed professionals such as doctors and lawyers. Many will be able to set their payments fully against income tax; but that still means more money for local revenues at, mainly, the centre's expense. The government also wants to close some tax loopholes, and give municipalities a larger share of the income tax. All told, the measures are supposed to boost municipal revenues by €4.5 billion next year, and €5 billion in 2005.

Splendid? No. No one is happy: not the opposition parties, of course, but nor yet Mr Schröder's own Social Democratic Party, nor, least of all, the towns and cities. They want more money; and they complain that the reform plans will turn the trading tax into a pure profits tax, which will sooner or later become part of the income tax, robbing them of their last bit of financial independence. The federation of municipalities plans mass rallies of protest across the country.

Given the backlash, the package will have to be amended, if it is to get through the Bundesrat, the upper house. Opposition parties have a majority there - and self-employed professionals are an important constituency for them.

So Germany is unlikely to get soon the sort of fiscal reform that experts like Fritz Scharpf, director of the Max Planck Institute for the Study of Societies, in Cologne, have long called for: a disentangling of the tax system, in which the different levels of government at present share most tax revenues, hoping to produce similar living conditions across the country. If, for instance, municipalities could instead fix and levy their own taxes, says Mr Scharpf, there would be more competition among them and more political accountability.

The planned overhaul of Germany's federal structure would be a good opportunity to tackle this fiscal issue. Yet the Lander, Germany's constituent states, do not even want to talk about it when negotiations start later this year.

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