Federal Fiscal Constitutions: Risk Sharing and Moral Hazard

The authors study collective choice of fiscal policy in 'federations.' Local policy redistributes across individuals and affects the probability of local shocks. Federal policy shares international risk but may induce local governments to enact policies that increase local risk. The resulting trade-off between risk-sharing and moral hazard is different under alternative fiscal constitutions because the constitutions create different incentives for policymakers and voters and give rise to different political equilibria. The authors specifically contrast vertically ordered systems, like the European Community, with horizontally ordered systems, like the United States. Under appropriate institutions, centralization of functions and power can mitigate the moral hazard problem. Copyright 1996 by The Econometric Society.