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Germany's Reform: One Small Step

Efforts to remodel federalism will give more flexibility to states in financial, educational, and environmental matters, says S&P

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At least one crucial reform measure, which began its legislative process through German Federal Parliament last week, is off to a promising start in Berlin. The agreement on a reform of the German system of federalism represents an important, albeit small, first step in the country's federalism-reform efforts, according to S&P's Ratings Services.

"It confirms the stability of the German system and its ability to reform," says S&P credit analyst Harald Sperlein. "We don't expect the ratings on either the Federal Republic or on German states to be affected by the current reform measures."

SETTING SALARIES.  The reform aims at a clearer separation of responsibilities that, up to now, the federal and state government have shared. Considered the broadest constitutional amendment since 1949, it's expected to result in a simplification of procedures in certain areas, such as education and environmental policy.

The financial position of the German federal states will primarily benefit from more financial flexibility on the expenditure side, as the states will gain the right to determine the salary of their civil servants. Furthermore, the states will receive responsibilities (including tax-setting rights) and all revenues for real estate transfer tax.

On the other hand, the states could end up burdened by obligatory payments of a 35% share of any potential monetary fine resulting from the country failing to meet the European Union's Maastricht Treaty criteria.

SNIPPETS OF AUTONOMY.  A structural reform of German federalism, which has both political and fiscal elements, poses a greater number of difficulties than it would in more-centralized states. About 60% of legislation passed at the federal level now requires the consent of the Bundesrat, the upper house of parliament representing the German federal states, compared with just 10% when the Federal Republic was founded. Over the past three decades, the Bundesrat has usually found itself dominated by the opposition parties, regardless of which parties formed the federal government.

As a result, federal governments have had only brief periods during which they could implement decisive and comprehensive reforms. More often, they were dependent on building consensus with the opposition. This has generally slowed Germany's reform progress, a factor that has grown to larger proportions and become more negatively felt in recent years, as both the economy and public finances have stayed tight.

"While the reform of federalism currently under discussion is a first step in the right direction, it fails to tackle the core of the problem: the extensive system of fiscal federalism," says Sperlein. Currently, many taxes are shared on federal, state, and municipal levels, as well as among states on a per-capita basis, distributing German tax revenues fairly evenly across the country. As a consequence, almost all changes to Germany's convoluted tax system require the consent of the states.

"TOO VAGUE."  Financial flexibility of individual states has been virtually nonexistent on the revenue side, consequently limiting the state governments' ability to actively manage their financial fate via expenditure flexibility. Despite far-reaching equalization effects, the current system has resulted in three out of the 16 states claiming extreme fiscal crisis.

A further-reaching change to the system of fiscal federalism, which is so far not part of the current plans, would give the states more autonomy to set and collect taxes. It would reduce the supportive element of the current system -- through higher tax allocation according to regional tax collection, for example -- and would increase individual financial revenue flexibility.

"The reform could therefore result in a widening divergence of the current ratings of the German states," says Sperlein. Such a comprehensive move to reform fiscal federalism is expected to remain on the agenda. However, the proposals remain too vague for serious evaluation. S&P will nevertheless closely follow any further developments.

From Standard & Poor's Ratings Services

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