Municipal Fiscal Adjustment in Germany

A large panel of German municipalities is employed in order to investigate the dynamic fiscal policy adjustment of local jurisdictions using a VEC model which explicitly takes account of the intertemporal budget constraint. The results confirm the central role of expenditure adjustment, nevertheless a substantial part of adjustment is due to changes in intergovernmental transfers, in particular, to “fiscal equalization” grants. While a comparison with U.S.-cities shows that transfers are also important in the case of the U.S., the overall contribution for fiscal adjustment is much larger in Germany. U.S.-cities mainly rely on own revenue, which has a negligible role for fiscal adjustment of German municipalities. However, reflecting the importance of the business tax in the local budget, in comparison to the case of the U.S. the extent of temporary fluctuations in own revenue is much higher in Germany. This higher extent of fluctuations is only partly compensated by the strong response in the fiscal-equalization transfers, and, as a result, expenditures fluctuate much more in Germany as compared to the U.S.