Working Paper: NBER ID: w3855
Authors: Xavier Sala-i-Martin; Jeffrey Sachs
Abstract: The main goal of this paper is to estimate to what extent the federal government of the United States insures member states against regional income shocks. We find that a one dollar reduction in a region's per capita personal income triggers a decrease in federal taxes of about 34 cents and an increase in federal transfers of about 6 cents. Hence, the final reduction in disposable per capita income is on the order of 60 cents. That is, between one third and one half of the initial shock is absorbed by the federal government. The much larger reaction of taxes than transfers to these regional imbalances reflects the fact that the main mechanism at work is the federal income tax system which in turn means that the stabilization process is automatic rather than specifically designed each time there is a cyclical movement in income. Some economists may want to argue that this regional insurance scheme provided by the federal government is an important reason why the system of fixed exchange rates that exists within the United States today has survived without major problems. Under this view, the creation of a European Central Bank that issues unified European currency without the simultaneous introduction (or expansion) of a fiscal federalist system could put the project at risk. Rough calculations of the impact of the existing European tax system on regional income suggests that a one dollar shock to regional GDP will reduce tax payments to the EEC government by half a cent!. Hence, the current European tax system has a long way to go before it reaches the 34 cents of the U.S. Federal Government.
Keywords: Fiscal Federalism; Optimum Currency Areas; Regional Income Shocks; European Currency
JEL Codes: E62; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Regional income shock (R11) | Decrease in federal taxes (H29) |
| Regional income shock (R11) | Increase in federal transfers (H77) |
| Decrease in federal taxes + Increase in federal transfers (H29) | Net reduction in disposable per capita income (D12) |
| Federal income tax system (H20) | Automatic stabilization of regional income shocks (E63) |
| Regional income shock (R11) | Federal government responses (taxes and transfers) (H29) |