The contribution of equalization transfers to fiscal adjustment: Empirical results for German municipalities and a US-German comparison

This paper considers the role of fiscal equalization in maintaining fiscal balance. It employs a large panel of German municipalities in order to investigate the dynamic fiscal policy adjustment using a vector-error-correction model that explicitly takes account of the intertemporal budget constraint. The results confirm that a substantial part of fiscal adjustment to revenue shocks takes place by offsetting changes in intergovernmental transfers: in present-value terms about 34 cents of a permanent 1 € decrease in own revenues are compensated by subsequent changes in fiscal-equalization transfers. Hence, the contribution of intergovernmental transfers in maintaining fiscal balance is found to be two to three times larger than in the case of US municipalities investigated by Buettner and Wildasin [Buettner, T., Wildasin, D.E., 2006. The dynamics of municipal fiscal adjustment. Journal of Public Economics 90, 1115-1132]. Despite fiscal equalization, however, expenditures are not found to display smaller fluctuations in the German case.