Even though the financial situations of Germany’s federal states differ significantly in some cases, according to the Bundesbank, the states as a whole are in better financial shape than the federal government. When other sources of revenue, such as fees, are taken into account, the states’ total revenue has exceeded that of the federal government for many years.

The main reasons for this are that the federal government has borne the bulk of the costs associated with both the pandemic and the energy crisis resulting from Russia’s war of aggression in Ukraine. Since the states have been constitutionally prohibited from taking on new debt since 2020, the financial imbalance between the federal government and the states continues to grow. In addition, the federal government finances some of the states’ constitutionally mandated responsibilities (23.9 billion euros in 2021, and the trend is rising). As a result, the federal government must either take out loans to maintain a balanced budget or cut back on urgently needed capital expenditures. Federal transfers to the states and federal-state finances must therefore be urgently restructured. In this context, not only the federal government but also the states must set clear priorities in fulfilling their responsibilities due to limited revenues.

Reform of Local Government Financing Is Urgently Needed

The problem of the lack of stable and crisis-proof financing for municipalities must finally be resolved. The current crisis has repeatedly highlighted the weaknesses in municipal financing and the need for a reform of local government finances. The goal is a modern system of municipal financing that meets both the requirements of modern corporate tax law and the financial needs of municipalities.

The COVID-19 pandemic has once again made it clear how fragile and volatile municipal financing through the trade tax is. The German Association of Cities expects trade tax revenue shortfalls of just under seven billion euros for 2021. The call from municipalities for financial aid is growing louder. A reform of municipal finances is therefore long overdue and, especially now in the wake of the COVID-19 crisis, absolutely essential.

Goal: Modern Municipal Financing

The goal is modern municipal financing that equally meets the requirements of corporate tax law and the financial needs of municipalities. After decades of attempts to address the shortcomings of the trade tax, fundamental reforms are now needed. Constructive approaches for integrating the trade tax into income taxes have long been on the table, enabling the tax burden to be spread across multiple shoulders and ensuring more stable municipal revenues. The trade tax must be replaced in a revenue-neutral manner while preserving municipalities’ right to set tax rates, thereby ensuring the long-term stability of municipal financing. Such a reform would place municipal financing on a broader footing, reduce its dependence on economic cycles, cut administrative burdens, and foster a stronger sense of identification among taxpayers with their municipalities. The current crisis—and the weaknesses in municipal financing that it has repeatedly exposed—now offer an opportunity to finally tackle a reform of municipal finances and the replacement of the trade tax.