Working Paper: CEPR ID: DP728
Authors: Torsten Persson; Guido Tabellini
Abstract: Inspired by current European developments, we study equilibrium fiscal policy under alternative constitutional arrangements in a `federation' of countries. There are two levels of government: local and federal. Local policy redistributes across individuals and affects the probability of aggregate shocks, while federal policy shares international risk. Policies are chosen under majority rule. There is a moral-hazard problem: federal risk-sharing can induce local governments to enact policies that increase local risk. We investigate this incentive problem under alternative fiscal constitutions. In particular, we contrast a `horizontally-ordered' federal system like the United States (in which the federal government deals directly with individuals) with a `vertically-ordered' system like the EC (in which the federal government deals with national states). These alternative arrangements are not neutral, in the sense that they create different incentives for policy-makers and voters, and give rise to different political equilibria. A general conclusion is that centralization of functions and power can be welfare improving under appropriate institutions. This conclusion only applies, however, to the moral-hazard problem and a federation where the countries are not too dissimilar.
Keywords: fiscal federalism; politics; risk sharing; principal-agent models; subsidiarity; investment subsidies
JEL Codes: D70; E15; E60; H10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| centralization of federal functions (H77) | mitigate moral hazard issues (G52) |
| federal government considering local incentives (H77) | reduce risk of local governments enacting policies that exacerbate national risk (H74) |
| centralized social insurance system (H55) | improve welfare (I30) |
| federal subsidies to local public investment (H54) | offset local distortions (H21) |
| centralization (H77) | beneficial under appropriate institutions (D02) |
| decentralization (H77) | spillover effects of policies across different governance levels (H10) |