Core competence: Fiscal federalism

Fiscal transfers in the spatial economy

Many countries shift substantial public resources across jurisdictions to mitigate spatial economic disparities. Despite this prevalence of fiscal transfers, surprisingly little is known about their economic implications. How do they affect aggregate economic activity and the distribution of population and income across space? How do they shape regional migration flows? What is their impact on productivity and welfare at the national level?

To shed light on those questions, we set up and quantify a general equilibrium model with multiple asymmetric regions, labor mobility, costly inter-regional trade, and inter-jurisdictional fiscal transfers. We calibrate the model, considering taxes and transfers as observed in (or recovered from) the data. The initial situation in our model represents a spatial equilibrium, in the sense that utility is equalized across space and individuals, who have idiosyncratic locational preferences, have no incentives to move anymore. In a counterfactual analysis, we then simulate how the equilibrium would change if Germany were to abandon all transfers completely. In that scenario, local public goods are financed solely by taxing local economic activity. Comparing this counterfactual to the actual equilibrium allows us to assess how, and through which channels, fiscal equalization affects the spatial economy. Afterward, we also explore optimal transfers and compare this hypothetical ideal to the currently implemented German equalization scheme.

Abolishing transfers raises national output but not welfare

In our counterfactual scenario, where all fiscal transfers are abolished, we observe a major migration wave out of the former recipient and towards the former donor regions. In total, we calculate that roughly 2.8 million people would change their local labor market in the transition to a new long-run spatial equilibrium. Some East German regions would lose almost one-quarter of their population, while big cities like Frankfurt or Munich would substantially grow. Fiscal transfers, therefore, seem to substantially affect people’s location choices.

As the induced migration is from less to more productive regions, we observe substantial gains in aggregate national output and productivity in our benchmark specification. Given our preferred set of parameters, we calculate that abolishing transfers raises average labor productivity by 3.4 percent and real GDP per capita by 2 percent. The left panel in Figure 2 illustrates the counterfactual change in national productivity for various parameter constellations. By retaining economic activity in the periphery, fiscal transfers, therefore, limit productivity and income dispersion, but this comes at the cost of lower national output and productivity.

Figure 2 (a and b): Impact of abolishing fiscal transfers on national productivity and welfare

However, when turning to national welfare, we find a different pattern. With our preferred baseline specification, we find that welfare even mildly decreases by 0.07 percent when transfers are abolished. In other parameter constellations, illustrated in the right panel of Figure 2, we sometimes obtain welfare losses and sometimes gains, depending on parameters. But even when there are welfare gains, they are consistently an order of magnitude smaller than the increases in national productivity and output. In other words, abolishing fiscal transfers from rich to poor regions within Germany will increase average productivity at the national level but it may decrease welfare.

What is the intuition of this result? The result is rooted in inefficiencies of the initial spatial equilibrium. One important channel in our model is that the former donor regions are already “too large” from a social point of view. This over-congestion results from various externalities that individuals ignore when choosing where to reside. There is a mix of positive and negative externalities in our framework, representing different agglomeration and congestion forces and the sharing of local public goods. But the combined net agglomeration externality that single individuals impose on others must be negative at the margin, otherwise it is difficult to rationalize why the economic geography of a country does not collapse into a single city. Hence, large cities can be “too large” although interregional transport costs and market size effects can work against this tendency.

The fiscal transfers that we observe effectively countervail over-congestion, because they provide incentives for workers to reside outside the big cities. This can be welfare-enhancing, especially if transport costs for goods are not too large and if the recipient areas are not too remotely located. Vice versa, abolishing the existing transfers can be bad for welfare, despite the associated productivity gains, because it can make the problem of over-congestion in large cities even worse. The fiscal transfers are surely, at most, a second-best instrument and do not implement an “optimal spatial structure” of the economy in any meaningful sense. But our results suggest that they may shift the economy closer to this optimum.

Our analysis also suggests that the current system of fiscal equalization in Germany is not socially optimal. Transfers should be reduced to enhance efficiency at the national level, but they should not be cut to zero. As an aside, this exercise highlights that national productivity or real GDP are the wrong statistics to look at when it comes to exploring the efficiency of fiscal transfers: starting from the current system, completely abolishing all transfers implies larger productivity and GDP gains than a mere reduction of current transfers to their optimal levels, but not higher welfare.