Highlights

The new fiscal equalization scheme (FAG) came into effect in 2024 and the fundamental structure of the tax-sharing mechanism remains unaltered under the revised agreement.  Austrian states continue to receive a fixed percentage share of overall tax receipts, particularly from personal income, corporate income, and value-added taxes, which are mainly determined by the states' relative population numbers.

Austrian states are required to return to defined deficit targets and debt limits following the deactivation of the "general escape clause" of the EU's Stability and Growth Pact.  The inner-Austrian stability pact (ÖstP) requires states to run cash accounts that are close to structural balance. The maximum allowed structural deficit (deficit adjusted for the economic cycle) is 0.1% of combined state and municipal GDP, which we estimate amounts to slightly less than 1% of states' combined operating revenues. States now need to rebalance their budgets to return to the balanced accounts and avoid sanctions.

Expenditure dynamics are outpacing tax revenue growth and will require further reform efforts from state and municipal governments.  We expect the slower-than-expected economic recovery will put pressure on states' budgets. The spending dynamics at state and local levels in areas such as health care, primary education, and social welfare--combined with a slowdown in revenue growth due to recent tax reforms, subdued growth, and falling inflation--mean that states and municipalities will need to pursue further structural and administrative reforms to contain expenditure growth and balance their budgets.

We expect Austrian states will seek new revenue sources or more taxation autonomy.  Previous renegotiations of the fiscal equalization system have exacerbated states' reliance on temporary transfers to cover financing needs and did not address structural imbalances between public service delivery responsibilities and funding.

We do not anticipate a change in our assessment of the institutional framework for Austrian states.  We expect the federal government will acknowledge and support funding needs, despite some political pushback. In our view, fundamental reforms are unlikely because we understand that Austria's political system is based on consensus decision-making. Additionally, any major amendments of the fiscal architecture require a constitutional reform bill that must be approved by a two-thirds majority in both chambers of the federal parliament, which we consider hard to achieve.

Trend: Stable

We could revise upward our assessment of the institutional framework in Austria if the different levels of government committed to a clearer separation of roles in the provision of public services and if the states' ability to formally influence the required revenue streams increased. States are responsible for implementing policies set by the federal government and must absorb costs, even though they have very little autonomy to raise the available financial resources accordingly. This results in their reliance on the periodic negotiations of the fiscal equalization system to address claims for additional resources. Enabling states to identify and leverage new revenue sources could improve their capacity to anticipate and manage expenditure dynamics and ensure adequate fiscal coverage.

We could revise downward our view of the institutional framework in Austria if we observe a reduction in the federal government's willingness to pursue negotiated and consensus-driven reforms, such as those related to the fiscal equalization system. This could result in more unilateral decision-making and would reduce states' ability to influence the outcomes of federal policy. As a result, system-distorting legal disputes and structural funding shortfalls could materialize if resources are not allocated as needed. We would also revise the institutional framework downward if Austria were to limit the states' extensive access to OeBFA funds significantly.

Predictability of the Framework

Regular and successful negotiations of the fiscal equalization agreement underpin Austria's consensus-oriented political system.  The degree of cooperation and cohesiveness among different levels of government in Austria is highlighted by the fact that they successfully renegotiate the fiscal equalization system about every four years, regardless of the composition of the respective governments and other challenges that arise within the negotiated periods. Although the federal government could introduce new equalization laws unilaterally, consultations and negotiations are the preferred modus operandi, despite potential difficulties and concessions. This means states have actual influence over the outcome.

We expect multi-year tax reforms at the federal level will affect overall tax revenue collection and increase funding shortfalls at the state and local levels. Recent reforms of the tax system include the reduction of the corporate income tax rate, the reduction of the wage and personal income tax, and the abolition of the "bracket creep" by adjusting tax brackets to account for varying inflation levels. These changes lead to a less dynamic increase in tax revenues, while structural demographic trends and general cost inflation continue to weigh on expenditure developments at the sub-national level. This scenario has rekindled the debate among different levels of government on the need for deeper structural reforms to the fundamental distribution of constitutionally assigned tasks and their respective funding.

Rather than major structural reforms, we expect incremental and gradual adjustments linked to bargaining on individual issues. After each round of negotiations on the periodic update of the financial equalization system, the results are considered only partially satisfactory by the different parties. We regard this as a positive feature and take it as evidence that real negotiations are taking place, compelling each side to make concessions, rather than the federal administration using its formal power to unilaterally impose changes. For instance, the latest round of negotiations did not result in an agreement on changes to the percentage-share of states in the overall tax revenue pool. Instead, it led to an increase in fixed-value, earmarked financial allocations to federal states and municipalities in specific areas, including health and social care, climate protection, housing, and primary education.

We note an increasing trend to use grant-type transfers from the federal to the state level to compensate for unbudgeted and rapidly rising expenditures. Local and regional governments (LRGs) receive substantial designated transfers from the federal budget (see chart 1). These transfers can come in the form of temporary special grants, financial allocations, or cost reimbursements. We generally see the federal government as very supportive of the lower levels of government, not least due to its very positive track record, which was evidenced during the COVID-19 pandemic and after recent disruptions following the escalation of geopolitical events. That said, we consider the predictability of unbudgeted and temporary transfers is less than ideal. We therefore think the increasing reliance on ad hoc or temporary transfers to cover mandatory expenditures constitutes the second-best solution.

Chart 1

Formal and informal mechanisms enable states to influence or oppose reforms.  Austria's fiscal decision-making is centralized in principle but based on a consensus-driven political system in practice. Austria's bicameral system consists of a National Council (Nationalrat) and a Federal Council (Bundesrat). The federal states are represented in the Bundesrat, while the Nationalrat is elected by universal suffrage on a proportional basis. Although both chambers can initiate legislation, most legislative prerogatives are concentrated at the federal level, with the states only being responsible for execution or implementation. With the exception of constitutional matters, where a two-thirds majority (also in the Bundesrat) is required for changes, the states' formal veto powers are somewhat limited and their ability to influence higher level governments' legislation and policymaking is not formally prescribed.

Beyond formal representation in parliament, states also wield informal influence through state governors and regional political parties. States' influence is particularly prominent in the case of financial equalization system negotiations. Since federal, state, and local governments share many responsibilities--such as education, social services, and public transportation--LRGs have a vested interest in determining how these responsibilities are shared and, more importantly, how they are co-financed. Since the federal government also relies on states to coordinate these tasks, negotiations are crucial, even though the federal level could, in principle, legislate unilaterally.

Revenue And Expenditure Balance

Most state revenues come from shared taxes, with federal transfers increasingly accounting for a larger share.  Austrian states have a very low degree of revenue autonomy, with low discretion in setting and collecting taxes. They are, in principle, protected from regional volatility in tax revenues by the tax-sharing mechanism at the federal level (the federal government collects more than 90% of all taxes). However, this also means that states have less scope to raise revenues unilaterally by introducing or adjusting taxes when needed. In theory, states may introduce new state taxes in areas that the federal government does not already tax--subject to a veto at the federal level--and can raise rates on existing state taxes. In practice, however, states' own tax revenues are negligible and only accounted for 7% of states' revenues in 2023 (see chart 1). Over two-thirds of states' revenues result from shared taxes, transfers, and subsidies.

Levies on municipal entities remain a prospective additional revenue source, whose usage varies across Austrian states. States can use three main levies to force municipalities to co-finance their expenditure in certain areas. These comprise a social welfare levy, through which municipalities co-finance 30%-50% of the state's welfare payments; a hospital levy, through which municipalities finance 10%-40% of the operating deficits of hospitals (in all states except Styria); and a provincial levy, which can amount to about 7% of overall revenue shares.

Sluggish economic growth dampens increases in shared taxes and intensifies the need for higher transfers from the federal government. The slower-than-expected increase in economic growth in 2024, after a technical recession in 2023, and the recent tax reforms in Austria suggest that the rise in shared tax revenues will be comparatively modest over the coming years, while mandatory expenditure items exhibit stronger trends, influenced by demographic trends and general cost inflation (see chart 2). The federal government included several additional transfer schemes in the new FAG to compensate for spending on dynamic, big-ticket items, such as healthcare, social welfare, and primary education. The states see this as transitional relief, but we expect them to push the federal government for more structural improvements that would translate into permanently higher funding levels.

Chart 2

Direct debt is on a downward trend after the pandemic-induced peak, with the federal debt agency OeBFA remaining the primary lender for most federal states. Indebtedness is moderate on average but varies considerably among entities. For example, Lower Austria and Carinthia's debt exceeded 100% of total consolidated revenues in 2023, while Tyrol's and Upper Austria's debt barely reached 20%. Although direct debt levels declined after 2021, they remain well above pre-pandemic levels. Due to lower deficits after capital accounts and economic growth increasing the ratio's denominator, we expect Austrian states' average direct debt burden will stabilize at about 45% by the end of the forecast period in 2026 (see chart 3). Due to the cost advantage of procuring funding directly from OeBFA, only few states borrow funds directly from the market, with Tyrol being the most notable exception.

Chart 3

Budgetary discipline is subject to monitoring and enforcement, in accordance with binding rules that apply to all government levels.  The ÖStP formally coordinates the budgetary policy among federal, state, and municipal levels. As an embodiment of the EU fiscal framework for budgetary discipline at the national level, it lays down the guidelines for the national debt brake and binds all levels of Austria's government to structurally balanced accounts. Apart from one-time or temporary measures, expenditures must match revenues, in line with the Maastricht Treaty and the structural deficit target. The end of the temporary suspension of the general escape clause of the EU Stability and Growth Pact--which was activated for three years over 2020-2023 in response to the COVID-19 pandemic and the energy crisis following the Russia-Ukraine war--means that member states are again subject to pre-defined deficit targets and stricter limits on debt accumulation (see chart 4).

Chart 4

Austria's stability pact includes a formal consultation mechanism to review and negotiate co-financing mechanisms if legislative proposals increase the financial burden. In case of disagreement on who should bear the additional costs of a new legislation, the authorities can refer the matter to the Federal Constitutional Court. We have, however, not observed any such disputes in recent years, which we attribute to the generally consensual nature of Austrian policymaking.

Although the federal government does not formally surveil states' finances, states might be subject to sanctions if they deviate from the targets set by the ÖStP. In this case, an arbitration panel would be formed by members of the federal government and representatives of the states to approve or endorse a corrective action plan for fiscal discipline. If financial sanctions are to be applied, the federal government can deduct them from the tax share that is allocated to the penalized entity. This is a harsh measure, which has not yet been observed, and we consider it unlikely that it will be pursued.

The Austrian Stability Pact will be amended in the context of the planned reform of economic governance at a European level, but member states have not reached an agreement yet. We do not expect any major changes to the ÖStP since Austria's official position in EU-level negotiations has been in favor of stricter rules.

The federal government does not guarantee states' debt but can provide financing via its debt agency.  The federal government does not guarantee states' debt and has no legal obligation to bail out local and regional governments. The track record of federal government intervention is also limited. This reflects the fact that federal states have generally shown a commitment to structurally balanced budgets, with the pandemic being the most notable exception. Austria's substantial pandemic-related support programs included extensive wage subsidy schemes, direct grants and state guarantees to companies, and transfers to LRGs to make necessary infrastructure investments related to immediate health needs. We see this as a positive development, compared with other occasions when the federal government has shied away from more timely and decisive interventions. This was the case when the then Austrian finance minister threatened to withhold shared taxes from the state of Carinthia to force Hypo Group Alpe Adria AG (HGAA) to cover losses at its former state-owned bank, before eventually deciding to provide supporting funds.

Austrian states generally benefit from seamless access to the federal debt agency's funds, which, in our view, implies an element of extraordinary liquidity support. States are required to indicate their borrowing needs at the beginning of each year. Provided they remain within their ÖstP deficit limits, the Minister of Finance usually grants formal approval without delay. Based on the current legislation, OeBFA can provide funding for any non-budgeted expenses, as well as refinance bond maturities and, very importantly, any intra-year debt if it is repaid by the end of the year. This supports our view that OeBFA plays a key role in the case of extraordinary liquidity needs. For example, OeBFA has been supportive in financing specific transactions, such as a federal credit line to support the state of Styria's acquisition of a 25% stake in ESTAG, which is now a wholly state-owned utility company.

Transparency And Accountability

In terms of the approval and execution of budgets, the responsibilities of executive and legislative government branches are clearly defined.  The executive, led by the state governor and the state government, is responsible for the preparation of the budget, which outlines proposed expenditures and expected revenues. The legislative body, known as the Landtag, is responsible for debating and approving the proposed budget, as well as passing additional requirements through legislation to be included in the budget. The executive is then responsible for implementing the approved budget, ensuring the proper management of the state's finances, and ensuring the appropriation. This process is supervised and monitored by the state parliament as well as other independent audit institutions.

The federal government continues to push for greater transparency from states and municipalities, especially regarding transfers and subsidy flows between them. The new FAG includes resources for a transparency portal where the states will be required to report on the use of funds and the achievement of certain mutually agreed and defined targets. The states' budget planning is typically very good and published yearly. Most states also prepare rolling medium-term financial plans for the next five years, but the quality and level of detail of these plans vary significantly.

States and local governments follow harmonized accrual accounting standards and annually publish income statements, cash flow statements, and balance sheets.  The Federal Ministry of Finance provides an online platform for public accounting, where a chart of accounts and an online bookkeeping and accounting manual are available. Information on federal, state, and municipal governments is compiled and made available to the public. In our view, Austrian states' financial reporting is well aligned with international best practices since the country introduced the currently applicable VRV 2015 accounting standard in fiscal year 2020 (ended Dec. 31, 2020). However, certain details are not provided, such as the full integration of the value of pension obligations in the balance sheet, the depreciation of assets, and a clearer classification of pass-through positions in the budgets.

Visibility on externalized financial obligations is limited if they are maintained outside the state's core budget. Even though we observe a higher level of consolidation of information related to state governments' financial obligations after the implementation of the VRV 2015 standard, consolidation is missing and information on "outsourced" financial obligations to government-related entities and other organizations can be insufficient. Most states resort to the creation of state-owned holding companies to manage the acquisition of assets and investments on behalf of the state as the ultimate guarantor. The visibility of financial commitments, the clear identification of risks, and the full value of liabilities are often not optimally reflected in states' financial statements and could increase contingent risk.

The system is characterized by robust control levels and the provision of very reliable information.  Budgets and accounts are fully harmonized by federal law, must be approved by the respective state parliaments, and are regularly audited by independent courts of accounts. Financial accounts are published annually in June or July. This compares well with most EU peers and provides an adequate level of transparency. We consider budgets and accounts are generally comprehensive and reliable, as indicated by the European Court of Auditor's reports.

Related Criteria

• Criteria | Governments | International Public Finance: Methodology For Rating Local And Regional Governments Outside Of The U.S., July 15, 2019

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