Local authority budget shortfalls and opportunities for a fresh start

“Just imagine: the financial situation of local authorities is dire and no solution can be agreed upon politically.” This statement may be a gross oversimplification, but it does provide a reasonably accurate description of the current situation. The reasons for the dire state of local authority finances are easy to explain. The low economic growth of recent years has had a significant dampening effect on tax revenue. At the same time, expenditure has risen sharply, particularly in the social sector and on local authority staff. This is due to the transfer and expansion of responsibilities, as well as increases in collective agreement rates and prices. Added to this are new requirements, for example with regard to the heating transition, digitalisation, climate protection and climate adaptation. The consequence: in 2025, there was a massive gap between revenue and expenditure for the third year running. The deficit of 29.4 billion euros was the highest seen since reunification. This situation is particularly problematic because it is unlikely to change much in the coming years. Relevant forecasts, such as those from the Federal Ministry of Finance, predict that the current deficits will become entrenched.

The immediate consequences are obvious: local authorities need to make savings. As a result, they often have no choice but to cut back on voluntary services or on investment in the maintenance and renewal of their infrastructure. The latter is particularly problematic because, according to Difu analyses, local authorities’ investment backlogs are already enormous, as can be seen in the latest KfW Municipal Panel 2026 (see p. 8 f. in this issue).

It is somewhat more difficult to describe possible indirect consequences: under the term “geography of discontent”, research teams are increasingly examining the consequences of persistently weak economic development in individual regions. In the medium to long term, these factors are reflected in a decline in the standard of public services and a deterioration in the condition of local infrastructure (see also the references listed under “Further reading”).

Several studies show that infrastructure provision has a significant impact on residents’ satisfaction and, consequently, on their voting behaviour. Findings from recent studies suggest that regional funding measures for infrastructure projects at state, federal or EU level could reduce the share of the vote won by right-wing populist parties. The direct positive effects of public infrastructure services – such as the provision of transport and healthcare services or childcare – on quality of life and economic development in structurally disadvantaged regions are cited as a possible channel of impact. It is also emphasised that the loss of well-paid jobs in the public sector, as well as what is perceived in some local authorities as a withdrawal of the state’s presence, can undermine the local population’s trust in state institutions.

The situation is made all the more acute by the fact that the immense pressure to act is coming up against the state’s currently limited fiscal capacity. In practice, none of the federal levels have any substantial scope for redistribution. The path towards higher levels of debt is also only viable to a certain extent, as it can only be pursued sustainably if, in the medium and long term, it is based on sufficient economic performance and the allocation of funds to investment for the purpose of building up the public capital stock. Furthermore, this option has already been pursued as part of the Special Fund for Infrastructure and Climate Neutrality, and there are regulatory limits on taking on further debt. All in all, this makes it difficult to repeat a response pattern that has been sufficiently practised over recent decades: solving new problems with ever-increasing amounts of money.

The multi-faceted crisis facing local authorities can only be tackled through reforms that focus on structural issues and on which the Federal Government, the states and local authorities must reach a joint agreement, as they are all in the same boat during this period of economic stagnation. Admittedly, the current budgetary situation does make it necessary to provide local authorities with financial relief in the short term. This could, for example, take the form of a temporary increase in the share of VAT taken by local authorities or relief for the cost of certain standard social benefits. In the long term, however, what is needed above all is structural reform, in which the range of local authority responsibilities is subjected to critical scrutiny and the institutional responsibilities and funding arrangements of the various social security systems are put under the microscope. Given the fragmented social security system – the ifo Institute identifies over 500 social benefits administered by different bodies – there are obvious opportunities to improve efficiency, particularly in the administrative sphere, by combining, digitalising and standardising these benefits. By consolidating responsibilities and avoiding the time-consuming duplication of beneficiary data across individual systems, local authorities will also have the opportunity, in the medium term, to deploy their increasingly scarce staff resources for other, more urgent tasks.

It will also be necessary to simplify the federal and state funding schemes, which have now become unmanageable, by merging and pooling them. This is because the allocation of funds from the local authorities’ share of the federal states’ special funds is carried out partly through existing funding programmes and partly through new ones. There are already some positive examples of simplifying the funding system to ensure that funds are allocated efficiently, with a focus on impact and with minimal red tape – particularly at state level. Furthermore, the federal and state governments’ federal modernisation agenda envisages, amongst other things, a simplification of the law governing grants, standardised funding guidelines and lump-sum allocations to local authorities as part of its plans for the future.

Furthermore, it is important to develop measures to ensure that the use of limited investment funds has the maximum impact in terms of economic, environmentally sustainable and socially inclusive urban development. Through targeted and sustained long-term efforts, local authorities must succeed in reducing their investment backlog as far as possible in the coming years.

It is also worth asking whether the role of local authorities within the federal system currently reflects their actual significance, and to what extent greater consideration should be given to the principle of subsidiarity. If local authorities represent the level within the federal state at which state services and decisions become directly visible and tangible to citizens, they should also have the capacity to act, including financially.