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Federal Fiscal Constitutions. Part I: Risk Sharing and Moral Hazard

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  • Torsten Persson
  • Guido Tabellini

Abstract

Inspired by the current European developments, we study equilibrium fiscal policy under alternative "federal" arrangements. Our model has two levels of government. Local policy redistributes across individuals and affects the probability of aggregate shocks, whereas federal policy shares international risk. Policies are chosen under majority rule. There is a tradeoff between risk-sharing and moral hazard: federal risk-sharing can induce local governments to enact policies that increase local risk. We analyze this tradeoff under alternative fiscal constitutions. In particular, we contrast a vertically ordered system like the EC with a horizontally ordered federal system like the US. These alternative arrangements create different incentives for policymakers and voters, and give rise to different political equilibria. Under appropriate institutions, centralization of functions and power can mitigate the moral hazard problem.

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Paper provided by Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics in its series EPRU Working Paper Series with number 93-04.

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Handle: RePEc:kud:epruwp:93-04

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  1. Sachs, Jeffrey & Sala-i-Martin, Xavier, 1992. "Fiscal Federalism and Optimum Currency Areas: Evidence for Europe from the United States," CEPR Discussion Papers 632, C.E.P.R. Discussion Papers.
  2. Wildasin, David E, 1990. "Budgetary Pressures in the EEC: A Fiscal Federalism Perspective," American Economic Review, American Economic Association, vol. 80(2), pages 69-74, May.
  3. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September.
  4. Alberto Alesina & Guido Tabellini, 1988. "Voting on the Budget Deficit," NBER Working Papers 2759, National Bureau of Economic Research, Inc.
  5. Bureau, Dominique & Champsaur, Paul, 1992. "Fiscal Federalism and European Economic Unification," American Economic Review, American Economic Association, vol. 82(2), pages 88-92, May.
  6. Grandmont, Jean-Michel, 1978. "Intermediate Preferences and the Majority Rule," Econometrica, Econometric Society, vol. 46(2), pages 317-30, March.
  7. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
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Cited by:
  1. Bolton, Patrick & Roland, Gerard & Spolaore, Enrico, 1996. "Economic theories of the break-up and integration of nations," European Economic Review, Elsevier, vol. 40(3-5), pages 697-705, April.
  2. Luca Agnello & Ricardo M. Sousa, 2009. "The Determinants of Public Deficit Volatility," NIPE Working Papers 11/2009, NIPE - Universidade do Minho.
  3. Caillaud, B. & Jullien, B. & Picard, P., 1996. "National vs European incentive policies: Bargaining, information and coordination," European Economic Review, Elsevier, vol. 40(1), pages 91-111, January.
  4. Fausto Hernández Trillo & Alberto Díaz Cayeros & Rafael Gamboa González, 2002. "Fiscal Decentralization in Mexico: The Bailout Problem," Research Department Publications 3143, Inter-American Development Bank, Research Department.
  5. Lejour, A.M., 1995. "Cooperative and competitive policies in the EU: The European Siamese twin?," Discussion Paper 1995-20, Tilburg University, Center for Economic Research.

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