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A Theory of Vertical Fiscal Imbalance

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  • Robin Boadway

    (Department of Economics, Queen’s University)

  • Jean-Francois Tremblay

    ()
    (Department of Economics, University of Ottawa)

Abstract

This paper examines how sequential decision-making by two levels of government can result in vertical fiscal imbalances (VFI). Federal-regional transfers serve to equalize the marginal cost of public funds between regions hit by different shocks. The optimal vertical fiscal gap minimizes the efficiency cost of taxation in the federation as a whole. The analysis shows how the existence of vertical fiscal externalities, leading regional governments to overprovide public goods, can induce the federal government to create a VFI by selecting transfers that differ from the optimal fiscal gap. When the federal government can commit to its policies before regional governments select their level of expenditures, the VFI will generally be negative. In the absence of commitment, the equilibrium transfer is unambiguously larger than the optimal fiscal gap, resulting in a positive VFI. In an intertemporal setting, the VFI has implications for the sharing of debt between the federal and regional governments.

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Bibliographic Info

Paper provided by University of Kentucky, Institute for Federalism and Intergovernmental Relations in its series Working Papers with number 2006-04.

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Length: 47 pages
Date of creation: Apr 2005
Date of revision:
Handle: RePEc:ifr:wpaper:2006-04

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