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(4) In cases to which subparagraphs 1 and 2of paragraph (1) of this Article apply, the Federation shall finance one halfof the expenditure in each Land. In cases to which subparagraph 3 of paragraph(1) of this Article applies the Federation shall finance at least one half ofthe expenditure; and the proportion shall be the samefor all Länder. Detailsshall be regulated by the law. The provision of funds shall be subject toappropriation in the budgets of the Federation and the Länder.

(5) Upon request the Federal Government andthe Bundesrat shall be informed about the execution of jointresponsibilities.

Article 91b relates to co-operation betweenthe Federal government and the states in education and research:

Pursuant to agreements the Federation andthe Länder maycooperate in educational planning and in the promotionof research institutions and projects of supraregional importance. Theapportionment of costs shall be regulated by the relevantagreement.

Other Specific-PurposeGrants

Article 106a [Federal grants for local masstransit] reads as follows:

Beginning January 1 1996 the Länder shall be entitled to anallocation from federal tax revenues for purposes of local mass transit.Details shall be the regulated by a federal lawrequiring the consent of the Bundesrat. Allocations made pursuant to the firstsentence of this Article shall not be taken into account in determining thefinancial capacity of a Land under paragraph (2) of Article 107.

Nature of Programs Focusedon Horizontal Imbalances

Article 107 of the Basic Law [Financialequalization] is directed at horizontal imbalances across states. It reads asfollows:

(1) Revenue from Land taxes and the Landshare of revenue from income and corporation taxes shall accrue to theindividual Länder tothe extent that such taxes are collected by revenueauthorities within their respective territories (local revenue). Detailsrespecting the delineation as well as the manner and scope of the allotment oflocal revenue from corporation and wage taxes shall be regulated by a federallaw requiring the consent of the Bundesrat. This law may also provide for the delimitation and allotment of local revenue from othertaxes. The Land share of revenue from the turnover tax shall accrue to theLänder on a per capitabasis; a federal law requiring the consent of the Bundesrat may provide for thegrant of supplementary shares not exceeding one quarter of a Land share toLänder whose per capitarevenue from Land taxes and from income and corporation taxes is below the average of allthe Ländercombined.

(2) Such a law shall ensure areasonable equalization of the disparate financial capacities of the Länder, with due regard for thefinancial capacities and needs of municipalities (associations of municipalities). It shall specify theconditions governing the claims of Länder entitled to equalizationpayments and the liabilities of Länder required to make them, as well as the criteria fordetermining the amounts of such payments. It may also provide for federalgrants to be made by the Federation to financially weak Länder from its own funds to assistthem in making their general financial needs (supplementary grants).

Article 107 therefore prescribes two formsof federal legislation (requiring consent of the Bundesrat): The first islegislation governing state-state equalizing transfers of local revenue(revenue from Land tax and the states’ share of revenue from theincome tax and corporation tax); the second is legislation governingsupplemental equalization payments, financed out of a 25% share of the VAT, tobe made to states whose per capita revenue from income and corporation tax isbelow the national average.

Equalization and theVAT

As mentioned, 75% of the states’ share of VAT revenues isdistributed on an equal per capita basis across states. This, then,incorporates a significant element of implicit horizontal equalization,transferring revenues from those states with above average VAT capacity tothose with below average VAT capacity. In fact, this implicit transfer isreferred to as first-tier equalization in the German system. One implication isthat the greater is the states’ share of VAT, the greater will be the level of first-tierequalization, and, hence, the less will be the need for explicit (second-tier)equalization.

The remaining 25% of the states’ share of VAT is used to fund asupplementary equalization scheme, directed at poorer states. Based on adjustedfiscal capacity for state taxes (defined below), states with fiscal capacitiesafter equalization below the national average are eligible for a VAT grant. Thegrant pool is, of course, restricted to 25% of VAT revenues. Hence, ifaggregate entitlements exceed the size of the pool, all entitlements arepro-rated accordingly (on an equal proportionate basis). If aggregateentitlements fall short of the size of the pool, the surplus is distributed toall states on an equal per capita basis.


State-state equalization operates as a netscheme—payments toreceiving states are just covered by contributions from paying states. For eachstate, equalization entitlements are calculated in steps with graduated ratesaccording to the difference between its adjusted fiscal capacity and itsindividual equalization standard. It is important to note that state-stateequalization is, in fact, a second-tier equalization process. That is,states’ fiscalcapacities include revenues from the VAT which are alreadyequalized.

Adjusted fiscal capacity (AFCi) is essentially aggregate state andlocal revenues (including shared taxes) with an adjustment for extraordinaryexpenditures for harbours. Aggregate state and local revenues include (a) staterevenues as specified under Article 106(2), (b) state revenues from joint taxesas specified under Article 106(3), distributed on a residence basis, (c) stateshare of VAT, and (d) local taxes.

The equalization standard for each state(ESi) is calculated asthe average per capita fiscal capacity for all states, scaled up (or down) toreflect the higher (lower) revenue needs associated with larger (smaller)population densities, times population. For cities, weights used to scale average per capita fiscalcapacity start with a value of 1.00 for cities with a population of 5,000 andmove up by steps to a value of 1.35 for cities with populations in excess of500,000. Population density is also taken into account in determining theoverall weight for each state.

State taxes are weighted by a factor of 1.35in city states to account for agglomeration diseconomies. Elsewhere theweighting factor is 1. For local taxes, weights rise progressively, based onpopulation size.

Table C-1: Weighting ofPopulation

Number of inhabitants of amunicipality


The first 5,000


The next15,000


The next80,000


The next400,000


The next500,000


All others above 500,000


Source: Extracted from Spahn (1997),143.

Furthermore, states with more than 500,000inhabitants receive additional points on their weighting factor according topopulation density. Those with between 1,500 and 2,000 inhabitants per squarekilometre receive an additional 2 percentage points; those with between 2,000and 3,000 inhabitants per square kilometre receive an additional 4 percentagepoints; and those with more than 3,000 inhabitants per square kilometre receivean additional 6 percentage points.

Those states with an adjusted fiscalcapacity between 92% and 100% of their equalization standard are equalized to37.5% of the difference. Thus, for such states, in symbols, equalizationentitlements are calculated as:

Ei = 0.375(ESi -AFCi).

States for which AFCi is less than 92% of their equalizationstandard are equalized at a marginal rate of 92% of the difference. Thus, forsuch states, in symbols, equalization entitlements (Ei) are calculated as:

Ei = (0.92ESi -AFCi) +0.375(ESi – 0.92ESi)

States with adjusted fiscal capacities abovetheir equalization standard are required to contribute to the equalizationpool. If the difference is less than 1% (that is, if AFC exceeds ES by not morethan 1%) they contribute 15% of the difference.28 Thus, the contribution tothe equalization pot is calculated as:

Ei = 0.15(AFCi– ESi).

States for which AFC exceeds ES by between1% - 10% contribute 66% of the difference.29 For such states, then,equalization entitlement is calculated as:

Ei = 0.15(1.01ESi– ESi) + 0.66(AFCi – 1.01ESi).

For differences in excess of 110% theycontribute 80% of the difference, or:30

Ei = 0.15(1.01ESi– ESi) + 0.66(1.1ESi – 1.01ESi) + 0.8((AFCi – 1.1ESi).

Since wealthier states—those with relatively high fiscalcapacities—tend to bethose with relatively high population densities, the scaling process tends tolessen the level of equalization flows at the second tier.

Where aggregate equalization payments exceed(fall short of) aggregate equalization contributions, state entitlements arepro-rated accordingly.

The German UnityFund

Incorporationof the former east German states into theFederation’s fiscalequalization scheme would have completely distorted the historic outcomes. Allbut Bremen among the recipient states would have become contributing statesand, as well, would have lost their federal supplementaryallocations.31 The 1990 Unification Treaty temporarily suspended the parts of theBasic Law relating to financial equalization (Article 107), providing a periodto review the equalization question, as they would otherwise have applied tothe new states through the beginning of 1995.

The German Unity Fund, co-financed by theFederation and the western states, was established as an interim programdirected at raising fiscal capacities in the former east German states tolevels comparable with those which would have prevailed had the temporarysuspension not been implemented. Of the DM115 billion in this fund, DM20billion was to be directly contributed by the federalgovernment in respect of financial savings arising from unification. Thebalance was to be financed through debt, the responsibility for which was to beshared equally by the Federation and the Länder (including local governments).In 1992 an additional DM31 billion was added to thefund, financed partly through a one-point increase in the VAT rate (DM23billion) and partly by the Federation (DM8 billion).

The Federation introduced an income taxsurcharge in 1991/92 (7.5% on all income tax payments) to assist in paying forthe Fund. In addition, they raised the mineral oil tax and the insurancetax.

States were partially compensated for theadditional burdens they assumed by a reapportioning of the VAT—from 63/37% to 56/44%.

Former federal supplementary grants were tobe replaced by two types of unconditional grants. Type A grants, payable toboth east and west German states, are designed to raise per capita revenues(after horizontal equalization) to 90% of the national average. Type B grantsare primarily directed at east German states in respect of infrastructuredevelopment.32

The fund was distributed among the newstates based on population. In turn, states were obliged to pass on 40% oftheir grant to their local governments.

Participation in financial equalization(Article 107) was extended to the east German states in 1995. Changes,reflected in the discussion above, were made with respect to the terms ofpayment for contributing states.

In each state, state-local equalizationschemes exist, based on the gap between need and fiscal capacity.

Table C-2: Fiscal Equalization Among States,1995

Relative Fiscal Capacity Per Capita (Average =100)

Public revenue per capita

Without VAT

After VAT distribution

After interstate equalization

After federal grants

Rank afterequalization



























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