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response to federal debt. The few observations available in the subsamples make inference more
awkward. One might read the shift from a negative to a positive response after 1991 as evidence of a
greater awareness of the sustainability problem since Reunification. The Lander instead ignore fiscal
sustainability altogether (Table 6). We find a significant negative reaction of the Land’s surplus to an
increase in Land debt if we control for the cyclical reaction of Land budgets. And whereas in the pre-
Reunification period, West-German Lander did not respond in any way to public debt, we find that
these Lander have seriously been running down surpluses since.22 Surprisingly, Lander budgets have
been procyclical since 1991, but were able to stem cyclical fluctuations before Reunification. In
contrast, the new Lander have set surpluses to counter debt rises in their region. To sum up, debt
problems seem to be inherent to the German fiscal system. After Reunification, these problems have
on the one hand been alleviated by the federal government, by absorbing some of the financing
problems of the new Lander and keeping federal debt under check. On the other hand, this exacerbated
fiscal tensions for the old Lander. It is less clear that these keep regional debt under control.
The reason for the strong differences in debt responses in the US and Germany could be of economic
or political kind. Given the strong similarities of both fiscal systems, one nevertheless wonders about
the strongly different outcome in terms of debt. Pork barrel politics could happen both in US states or
German Lander. Government spending benefits local citizens but the costs in terms of tax increases
are borne by the common pool of tax payers. Nonetheless, the debt problem seems to be intrinsic to
the set up of the German fiscal system. And there has been no major shift in sustainability with
Reunification. Rodden et al. (2003) attribute the lack of fiscal discipline in Germany to the
cooperative approach to fiscal federalism. I.e., the federal and Land governments overlap in their
spending competences, and share revenues on common tax bases with a strong degree of
harmonisation of tax rates. Moreover, a large share of spending and the majority of tax decisions are
made after an agreement has been reached between the federal government and all Lander.
Cooperative fiscal federalism substantially complicates the setting of federal and regional budgets as
adjusting the spending or revenue sides of the budget becomes rather complicated. The build-up of
debt at regional level does not depend on the overall degree of vertical fiscal imbalance, but on the
financing of this gap. In particular, Laubach (2006) hypothesises that fiscal systems financed by
horizontal grants reduce incentives for regional governments to take debt developments in
consideration. Vertical transfers instead give the federal government leverage over the fiscal policy of
every region. In this way, the central government internalises the effects of regional fiscal policies in
its grants scheme. The internalisation of the effects on the aggregate debt position renders the regional
budgets more responsive to debt build up. In contrast, if horizontal transfers make up the major part of
22 Many Lander disregard sustainability of their debt at the regional level. The results for individual fiscal rules
are not reported.
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