Fiscal Transfer Unions: US, Germany, EU(?)

Photo by Lawrence Chard (Flickr.com)

The Economist recently posted an interesting article on fiscal transfers between the sixteen German states, with the subtitle “Germans fear a European transfer union because they hate their own one.”The article offers interesting peeks into the fuss over tax revenue redistribution in Germany (to cite one example: education is free in Berlin, while in Bavaria it is not, even though Bavaria subsidizes Berlin’s budget). But the article and its subheading cast a very cynical and gloomy shadow on a European project that hasn’t even begun.

The gist of the article is that the “system of financial equalization” is illustrative of how redistribution can generate “conflict” and “perverse incentives,” especially when there exists a big economic gap between states. The article sets out to draw lessons for the European fiscal transfer union, a solution suggested for the continuing financial crisis. But without explaining why fiscal transfers can be important, the article simply assumes that the EU transfers will be fussy and difficult, as it is difficult even within one small nation.Many critics of the EU fiscal transfer plan voice similar concerns: by constantly subsidizing states that do not perform so well economically, transfers can prolong the perverse incentive to free ride and reduce incentives to make economies productive.

But these criticisms don’t take into account why fiscal unions were adopted in Germany, and why they are being proposed in the EU today: fiscal unions can help maintain the integrity and stability of a financial system. The continuing financial crises offer strong evidence that a monetary union cannot work without fiscal union. Without a federal system to manage macroeconomic imbalances, the euro is vulnerable to asymmetric shocks, and predatory markets will be able to prey on the weakest members of the euro and shake the system hard. A stable fiscal transfer system is important for a viable monetary union.

The United States is another fiscal union that the EU can look for advice. America’s founding states made the leap towards fiscal union 221 years ago, and since then, US’s credit has survived many wars and depressions.

chart and map of US federal transfers over the past twenty years suggest the drastic amounts that are being transferred in the American fiscal union. Virginia, for instance, has received more transfers from the federal government than it has collected in taxes between 1990-2009. The transfers received by Virginia amounts over twenty years amounts to 145% of Virginia’s 2009 economic output. An article analyzing this chart points out that this figure is similar to Greece’s debt-to-GDP ratio. “If America were like the euro area, Virginia would have to bear the burden itself.” Virginia is not the outlier of the system. At the end of the spectrum stand New Mexico and Puerto Rico, and these sums have not yet been adjusted to include interest payments on debt. Perhaps such drastic transfers are a necessary part of a functioning system.

But Europe is a community of independent nations. Will they eventually give up sovereignty as the founding American states did two centuries ago?

SUGGESTED ARTICLES