"And the last shall be first..."

This paper explores the political economy of fiscal policy in the German Länder, testing several theories from the cross-national literature on budget deficits along with some additional hypotheses relating to the incentives created by the German federal system. The results suggest that governments controlled by the left spend and borrow more in the long run than right-wing governments, though short-term partisan differences in fiscal management cannot be identified. Furthermore, incumbents spend and borrow more during election campaigns, and contrary to common wisdom, Land fiscal policy is decisively pro-cyclical. The most striking findings have to do with Germany’s peculiar system of intergovernmental grants. Although transfers have a positive effect on fiscal balance in the short term, states increase expenditures and deficits in the long run as they grow more dependent on transfers. The results may have implications for other fiscal systems where lower-level governments have wide-ranging expenditure and borrowing autonomy but little authority to tax.