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Fiscal Federalism and Optimum Currency Areas: Evidence for Europe from the United States

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  • Sachs, Jeffrey
  • Sala-i-Martin, Xavier

Abstract

The main aim of this paper is to estimate the extent to which 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 reduction 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 around 60 cents. That is, between one-third and one-half of the initial shock to the region is absorbed by the Federal Government. Taxes respond more strongly to regional imbalances than do transfers. The main mechanism at work is the federal income tax system, which implies that the stabilization process is automatic rather than specifically designed each time there is a cyclical movement in income. Some economists may argue that this regional insurance scheme, provided by the Federal Government, is an important reason why the US system of fixed exchange rates has survived without major difficulties. According to this view, Europeans who look to the United States as a model for Europe should seriously consider the creation (or expansion) of a federal fiscal system at the same time as they create a European Central Bank that issues a unified European currency. The creation of the latter without the insurance mechanism provided by the former could endanger the entire process of monetary unification. Approximate 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 EC government by half a cent. Hence, the current European tax system has a long way to go before it reaches the 34 cents response of the US system.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 632.

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Date of creation: Mar 1992
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Handle: RePEc:cpr:ceprdp:632

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Keywords: Exchange Rate; Exchange Rate Arrangements; Fiscal Federalism;

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  1. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(1), pages 101-121.
  2. Maurice Obstfeld, 1984. "Capital Controls, The Dual Exchange Rate, and Devaluation," NBER Working Papers 1324, National Bureau of Economic Research, Inc.
  3. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec..
  4. Olivier J. Blanchard, 1984. "Debt, Deficits and Finite Horizons," NBER Working Papers 1389, National Bureau of Economic Research, Inc.
  5. Thomas Willett & Edward Tower, 1970. "Currency areas and exchange-rate flexibility," Review of World Economics (Weltwirtschaftliches Archiv), Springer, Springer, vol. 105(1), pages 48-65, September.
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  1. L'uscita dell'euro redux: la Realpolitik colpisce ancora
    by Alberto Bagnai in Goofynomics on 2011-11-29 08:56:00
  2. A domanda rispondo
    by Alberto Bagnai in Goofynomics on 2012-11-25 22:59:00
  3. Convergiamo? In tanto tempo forse ci riusciamo...
    by Alberto Bagnai in Goofynomics on 2013-09-11 10:19:00
  4. Le aporie del piĆ¹ Europa
    by Alberto Bagnai in Goofynomics on 2012-08-05 15:59:00
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