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On the Optimal Design of Disaster Insurance in a Federation

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  • Timothy J. Goodspeed

    () (Hunter College and Graduate Center of CUNY, Department of Economics, 695 Park Avenue, New York, NY 10021)

  • Andrew Haughwout

    (Research and Statistics Group, Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045)

Abstract

Recent experience with disasters and terrorist attacks in the US indicates that state and local governments rely on the federal sector for support after disasters occur. But these same governments are responsible for investing in infrastructure designed to reduce vulnerability to natural and man-made hazards. This division of responsibilities – state governments providing protection from disasters and federal government providing insurance against their occurrence – leads to the tension that is at the heart of our analysis. We explore these tensions building on the model of Persson and Tabellini (1996). We show that when the federal government is committed to full insurance against disasters, states will have incentives to underinvest in costly protective measures. We then show that when the central government cannot verify state investment choices, the optimal insurance system would be designed to reward states that succeed in avoiding disasters and punish those that do not, thereby giving states an incentive to increase investment in protective infrastructure. However, this raises the question of whether the central government can credibly commit to such a scheme, and we find in a simple political model that it cannot. In our political model, the central government will decrease transfers ex-post if a state provides protective infrastructure that increases its expected uncertain income, generating a soft-budget constraint for states. This provides an additional incentive for states to underinvest in protective infrastructure. We discuss these results in light of disaster policy in the US.

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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 2006-14.

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Length: 27 pages
Date of creation: Nov 2006
Date of revision:
Handle: RePEc:ifr:wpaper:2006-14

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  1. Gary S. Becker, 1974. "A Theory of Social Interactions," NBER Working Papers 0042, National Bureau of Economic Research, Inc.
  2. Gilberto Turati & Luigi Buzzacchi, 2009. "Optimal risk allocation in the provision of local public services: can a private insurer be better than a public mutual fund?," Working Papers 2009/21, Institut d'Economia de Barcelona (IEB).
  3. Bruce, Neil & Waldman, Michael, 1990. "The Rotten-Kid Theorem Meets the Samaritan's Dilemma," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 155-65, February.
  4. Timothy Goodspeed, 2002. "Bailouts in a Federation," International Tax and Public Finance, Springer, vol. 9(4), pages 409-421, August.
  5. Horst Raff & John Wilson, 1997. "Income Redistribution with Well-Informed Local Governments," International Tax and Public Finance, Springer, vol. 4(4), pages 407-427, November.
  6. Bayoumi, Tamim & Masson, Paul R., 1995. "Fiscal flows in the United States and Canada: Lessons for monetary union in Europe," European Economic Review, Elsevier, vol. 39(2), pages 253-274, February.
  7. Bordignon, Massimo & Manasse, Paolo & Tabellini, Guido, 1996. "Optimal Regional Redistribution Under Asymmetric Information," CEPR Discussion Papers 1437, C.E.P.R. Discussion Papers.
  8. Lockwood, Ben, 1997. "Inter-Regional Insurance," Discussion Papers 9703, Exeter University, Department of Economics.
  9. Persson, Torsten & Tabellini, Guido, 1996. "Federal Fiscal Constitutions: Risk Sharing and Moral Hazard," Econometrica, Econometric Society, vol. 64(3), pages 623-46, May.
  10. Nobuo Akai & Emilson Silva, 2009. "Interregional redistribution as a cure to the soft budget syndrome in federations," International Tax and Public Finance, Springer, vol. 16(1), pages 43-58, February.
  11. Thomas A. Garrett & Russell S. Sobel, 2003. "The Political Economy of FEMA Disaster Payments," Economic Inquiry, Western Economic Association International, vol. 41(3), pages 496-509, July.
  12. Melitz, Jacques & Zumer, Frederic, 2002. "Regional redistribution and stabilization by the center in Canada, France, the UK and the US:: A reassessment and new tests," Journal of Public Economics, Elsevier, vol. 86(2), pages 263-286, November.
  13. Caplan, Arthur J. & Cornes, Richard C. & Silva, Emilson C. D., 2000. "Pure public goods and income redistribution in a federation with decentralized leadership and imperfect labor mobility," Journal of Public Economics, Elsevier, vol. 77(2), pages 265-284, August.
  14. David Wildasin, 2007. "Disaster Policy in the US Federation: Intergovernmental Incentives and Institutional Reform," Working Papers 2007-01, University of Kentucky, Institute for Federalism and Intergovernmental Relations.
  15. Martin Besfamille & Ben Lockwood, 2008. "Bailouts In Federations: Is A Hard Budget Constraint Always Best?," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 49(2), pages 577-593, 05.
  16. Cornes, Richard C. & Silva, Emilson C. D., 2000. "Local Public Goods, Risk Sharing, and Private Information in Federal Systems," Journal of Urban Economics, Elsevier, vol. 47(1), pages 39-60, January.
  17. Bergstrom, Theodore C, 1989. "A Fresh Look at the Rotten Kid Theorem--and Other Household Mysteries," Journal of Political Economy, University of Chicago Press, vol. 97(5), pages 1138-59, October.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Local authorities under-invest in disaster prevention
    by Economic Logician in Economic Logic on 2009-12-17 21:24:00
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Cited by:
  1. Gilberto Turati & Luigi Buzzacchi, 2009. "Optimal risk allocation in the provision of local public services: can a private insurer be better than a public mutual fund?," Working Papers 2009/21, Institut d'Economia de Barcelona (IEB).
  2. Hikaru Ogawa & David Wildasin, 2007. "Think Locally, Act Locally: Spillovers, Spillbacks, and Efficient Decentralized Policymaking," Working Papers 2007-06, University of Kentucky, Institute for Federalism and Intergovernmental Relations.
  3. David Wildasin, 2007. "Pre-Emption: Federal Statutory Intervention in State Taxation," Working Papers 2007-05, University of Kentucky, Institute for Federalism and Intergovernmental Relations.
  4. Christos Kotsogiannis & Robert Schwager, 2006. "Fiscal Equalization and Yardstick Competition," CESifo Working Paper Series 1865, CESifo Group Munich.
  5. Kai A. Konrad & Marcel Thum, 2012. "The Role of Economic Policy in Climate Change Adaptation," CESifo Working Paper Series 3959, CESifo Group Munich.
  6. Lohse, Tim & Robledo, Julio R., 2012. "Public self-insurance and the Samaritan's dilemma in a federation," Discussion Papers, Research Professorship & Project "The Future of Fiscal Federalism" SP II 2012-103, Social Science Research Center Berlin (WZB).
  7. Luigi Buzzacchi & Gilberto Turati, 2009. "Collective Risks in Local Administrations: Can a Private Insurer Be Better than a Public Mutual Fund?," Working papers 3, Former Department of Economics and Public Finance "G. Prato", University of Torino.

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