Ifo Viewpoint No. 55: Equivalent Standards of Living and Factor Price Equalization

Hans-Werner Sinn
Munich, 15 September 2004

According to Article 107 Basic Law, there must be fiscal equalization among the federal states, and according to Article 72 Basic Law, the federal government has the right to assume legislative powers if it wants to create equivalent standards of living in different regions of Germany. It has, however, neither the duty to do so, nor have the regions or anybody else the right to demand the creation of equivalent standards of living. And, above all, they have no right to public funds for the purpose of creating equivalent standards of living. That is all to the good, for in a market economy the state lacks the instruments to achieve such a goal.

The market economy itself already provides for extensive convergence of the standards of living. Market arbitrage brings about a convergence of prices and incomes that is only limited by transportation costs. Capital moves wherever wages are low and labour moves to regions where wages are high and where there are jobs. This process puts downward pressure on wages in highwage regions and upward pressure on wages in low-wage regions. The result is what economists call factor price equalization. This may not suffice to create equivalent standards of living in a deeper ethical sense, but it already achieves a good deal.

The state must not do more than support this natural convergence process. If it tries to accelerate the process by financial means provided to the citizens in the weaker regions, it frequently achieves the opposite of what is intended. The beneficiaries now are induced to change their economic behaviour in a way to receive more of these funds. Attempts to earn money by selling their own services to other citizens, which after all is the fundamental principle of a market economy, thus take the backseat.

Thus, most of the state funds, which flowed to the east German states, were spent on welfare benefits of various kinds. In this way the state became a competitor of business, pushing up wages, thereby making the establishment of companies more difficult and causing mass unemployment. With this policy it has not supported the convergence of living standards, but impaired it massively. Only infrastructure services and similar measures, which raise productivity in the weaker regions, can promote a convergence of living standards, but unfortunately most state funds do not flow there.

Insofar, President Köhler’s warning is appropriate. It is easier to live with the small differences left by a truly free market than with the chaos and the inequality created by the attempt to produce uniform standards of living by the use of fiscal measures.

Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute