The political economy of local fiscal equalization in the German States

• Applicant: Professor Dr. Thushyanthan Baskaran
• Subject Area: Economic Policy, Applied Economics
• Term: from 2014 to 2017
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 240136259

• Final Report Year: 2017

Final Report Abstract

This project’s main aim was to explore intergovernmental equalization in the German States form a political economy perspective and with a quasi-experimental methodology. In addition, we used the data collected for the main part of the project to study political decisions at the local level in Germany in general as well as fiscal policy choices in other contexts, notably Portugal. Important findings of the project include that political variables can be important determinants of intergovernmental transfers in Germany. Specifically, we find that the alignment status of a municipality matters for the amount of transfers a given municipality receives. What is surprising, however, is that the effect of alignment is not constant but varies both according to the transfer program in question as well as the prevailing political conditions. Specifically, we find that aligned municipalities are treated more harshly in special needs / bailout transfer allocations. One explanation for this finding is arguably that bailout transfers carry a stigma and indicate a form of fiscal policy failure. The state government may be less willing to grant such transfers to aligned municipalities due to fear of negative reputational spillovers onto the party brand. On the other hand, aligned municipalities can benefit in the allocation of other, more standard types of discretionary transfers. However, the results also indicate that the degree to which they benefit depends on the extent of local support the state government enjoys, i. e. the number of municipalities that are aligned with the state government. Overall, the results highlight that while political-economy variables matter for transfer allocations, the exact nature of the relationship is highly idiosyncratic. Another set of important findings relates to the consequences of intergovernmental transfers. Specifically, the project establishes that transfers, and more generally the statutory rules that govern the allocation of transfers, affect the policy choices of local governments and, through this channel, have important fiscal consequences. First, it is found that bailout transfers have a significant effect on fiscal policy. Municipalities that receive bailouts appear to consolidate their budgets – they cut expenditures, raise taxes, and reduce deficits. These findings indicate that bailout transfers do not necessarily have to lead to soft budget constraints but that, instead, the austerity conditions that often accompany bailouts appear to be effective at last in the German context. The project also finds that reforms of the local fiscal equalization schemes can have significant effects on fiscal policy choices, in particular on the choice of local tax rates, even if these reforms do not substantially affect the actual allocation of transfers across municipalities. Third, it is also found that an increase in transfers causes a disproportional large increase in expenditures, contradicting standard median voter models and pointing toward a flypaper effect. Overall, the results from this project indicate that in Germany, political considerations are important for how higher-level governments allocate transfers as well as for how transfers are used by the municipalities. However, more general statements cannot be made as the causes and consequences of transfers vary according to circumstances as well as the specific nature of the transfer program. This heterogeneity points to the need to analyze the political economy of intergovernmental transfers in more detail in the future.

Publications

• (2017) Political alignment and intergovernmental transfers in parliamentary systems: evidence from Germany. In: Public Choice 171 (1-2) 75–98
  Baskaran, Thushyanthan; Hessami, Zohal
  
• (2016). Do municipal mergers reduce costs? Evidence from a German federal state. Regional Science and Urban Economics 59, p. 54-74
  Blesse, S. and T. Baskaran
  
• (2016). Electoral competition and endogenous political institutions: Quasi-experimental evidence from Germany. Journal of Economic Behavior & Organization 122, 43-61
  Baskaran, T. and M. Lopes da Fonseca
  
• (2016). Electoral thresholds and political representation. Public Choice 169, p. 117-136
  Baskaran, T. and M. Lopes da Fonseca
  
• (2016). Intergovernmental transfers, local fiscal policy, and the flypaper effect: evidence from a German State. FinanzArchiv: Public Finance Analysis 72, 1-40
  Baskaran, T.