Fiscal transfers in a two-level fiscal framework: stabilizing properties according to the fiscal instrument

In a two-country extit{Dynamic and Stochastic General Equilibrium} (DSGE) model, we document the stabilizing properties of fiscal transfers between currency union members according to the nature of the fiscal instrument used with these transfers. To do this, we model a two-level fiscal framework for the monetary union in which the central authority collects one share of national fiscal revenues and determines how these revenues are redistributed among countries following a simple fiscal transfer rule. We assume that the central authority is allowed to decide how the recipient economy use these funds. The main result of this paper is that the stabilizing properties of fiscal transfer schemes strongly depend on the fiscal instrument and on the nature of the idiosyncratic shocks which hit member states. Transfers to households and VAT are more effective to stabilize macroeconomic differentials between both economies of the currency union when asymmetric demand shocks occur while the labor income tax and the social protection tax are more effective in the case of an asymmetric productivity shock. This article then participates to the debate about the way fiscal policy should be structured within the Euro Area. Indeed, we argue within this article for the implementation of a fiscal transfer mechanism taking into account the nature of the fiscal instrument and the nature of idiosyncratic shocks.