Is the Local Business Tax a User Tax? - An Empirical Investigation for Germany

The theory of fiscal federalism argues that local governments should only tax mobile tax bases for the purpose of charging user taxes which correct for congestion effects. Empirically, we observe that local governments do levy taxes on mobile bases. In Germany, this is the local business tax (Gewerbesteuer). Since such taxes are efficient only if they are raised to cover congestion effects, the justification for these taxes usually put forward is that they serve as user taxes. This paper tests empirically whether that justification holds for the case of German local business taxes. Our findings do not support the user tax argument. Instead, our results suggest that local governments use the local business tax as a source of revenue for general public expenditures. Our empirical analysis finds statistically significant positive effects of changes in expenditures for social assistance and interest payments on subsequent tax rate changes. Our results are thus consistent with the view prevailing in the literature according to which local business tax rates are set in response to general financial pressure in local government budgets.