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Monthly Report: Limit local government cash advances and stabilise financing

According to the current issue of the Monthly Report, prior to the coronavirus crisis local government finances were in good shape overall, albeit with major differences from municipality to municipality. Now, however, due to budget gaps that have emerged as a result of the pandemic, the report points to a risk of local governments increasingly turning to cash advances to finance their budgets. Cash advances are only actually intended for short-term use as a temporary measure to keep a municipality afloat over one year. If loans of this kind end up persisting beyond the fiscal year, the Bundesbank’s economists see this is a sign of unresolved budget problems. These drawn-out problems then put local governments under increasing pressure as time goes on. The Bundesbank is therefore proposing a three-pronged approach to stabilising local government finances: first, reform and strengthen local government financing; second, reduce the volume of legacy cash advances; and third, prevent budget problems from building up again in the future. 

Persistent cash advances sign of unresolved budget problems in numerous municipalities

Local government budgets recorded large surpluses prior to the coronavirus crisis, the Bundesbank’s experts write in its Monthly Report. However, sizeable cash advances continued to persist in the municipalities of some federal states. Cash advances are only actually intended to enable local governments to bridge short-term liquidity shortfalls over one fiscal year. However, in some cases they have been used to plug persistent budget gaps. “Multi-year cash advances are thus indicative of local government budget imbalances that have not been resolved,” the economists write. It was possible to bring cash advances down by just over one-quarter from their peak of around €51 billion at the end of 2015 to €37 billion at the end of 2020.

According to the Monthly Report, fiscal surpluses and, not least, state governments’ debt relief programmes had a role to play in this. Nevertheless, the volume of cash advances is still significant in the municipalities of some federal states.

As their revenue prospects also lag behind their pre-crisis levels over the medium term, the economists believe there is now a renewed risk of local governments increasingly turning to cash advances to finance their budgets and of their financial problems growing.

State governments share responsibility for ensuring sound finances

For the Bundesbank’s economists, it is the federal states that bear the lion’s share of the responsibility for keeping their municipalities’ finances in order. They have to ensure the provision of adequate funding through their local government financial equalisation schemes. Additionally, they are responsible for monitoring budget planning and have extensive powers of intervention. From the Bundesbank’s perspective, there are three big starting points for stabilising local government finances.

Reform local government financing

First, a fundamental reform of local government financing to stabilise the current local government revenue volatility would be a welcome development. The Bundesbank already made some proposals for reform back in 2020: one of these was to reduce the weight of the highly volatile local business tax in the total tax revenue received by local governments. In return, the economists proposed raising local governments’ share of more stable sources of revenue, such as wage tax revenue. Another possible option is to give municipalities the power to set their own local multipliers on a share of general income tax.

Reduce the volume of legacy cash advances

Second, state governments need to ensure that their local governments’ high levels of cash advances are reduced. The spotlight here is on Rhineland-Palatinate, which holds top position with a per capita cash advance amount of €1,610, followed by Saarland (€1,410) and North Rhine-Westphalia (€1,180). “Debt relief programmes run by state governments, such as the one in Hesse, appear to be sensible approaches to handing financial flexibility back to local governments in future,” the economists write, noting that programmes of this kind need to be accompanied by rules which, going forward, safeguard sound finances and ensure that location conditions are suitably attractive.

Prevent new budget imbalances

Third, the Bundesbank’s experts note the importance of, wherever possible, preventing structural budget imbalances from materialising in future. They state that this is conditional on federal states being consistent in their monitoring and addressing unwelcome developments early on. In order to underscore state governments’ responsibility and take account of this more formally, a rule could be put in place stipulating that local governments are only permitted to obtain cash advances that would not be repaid by the end of the fiscal year from their home state government. Local governments’ financial problems would then be reflected in state government budgets with little time lag and transparently reported to the public in the budgetary accounts, the Bundesbank writes. If the necessary borrowing were to also count towards federal states’ debt brakes, it adds, this would provide them with an added incentive to prevent local government budget imbalances from occurring.