Germany’s Länderfinanzausgleich (Interstate Fiscal Equalisation System) redistributes tax revenues not only between the Federal Government and Germany’s sixteen states or Länder but also among the states themselves. The mechanism is intended to ensure that all regions enjoy the same standard of living.
How much money a state receives or has to pay depends on its per capita tax revenue compared to the national average. The system generally assumes that all states have the same financial needs per inhabitant, but accepts that the requirements of the city states, such as Berlin, and sparsely populated ones, such as Mecklenburg-West Pomerania, are higher. For years, Bavaria has been the largest donor, followed by Baden-Württemberg and Hesse. All other state are beneficiaries - with Berlin receiving the most.
The Interstate Fiscal Equalisation System also includes supplementary federal allocations, for example for the programme of rebuilding in the former-communist eastern part of Germany. The resources devoted to this so-called Solidarity Pact II decrease annually and the programme will expire in 2019. The other rules of the Interstate Fiscal Equalisation System will also lose their validity at the same time and will be replaced from 2020 by a new Financial Strength Equalization System. The latter will replace payments between the states by the federal government distributing revenue from VAT so as to considerably reduce inequalities. However, the new system gives the recipient countries less incentive to increase their own tax revenues, so that donor and recipient states may continue to diverge fiscally. If this happened, the federal government would have to intervene more and more to compensate for the differences.