Disasters and Decentralisation

Climate change may potentially increase the magnitude of losses from natural hazards, but the United States experience shows that the primary reason for escalating losses is policy failure. It is well known that centralised, taxpayer-funded ex post disaster relief has actually encouraged development in risky jurisdictions and also weakened incentives for ex ante precautions in such jurisdictions (moral or “charity” hazard). Less well known and analysed is the role played by centralised ex ante development subsidies—often masquerading as protective investment—in distorting incentives. This paper develops a simple three jurisdiction model in which homogeneous jurisdictions decide by majority vote in a centralised legislature on the centralised (federal) share of ex post loss and centralised spending an ex ante development in a Beneficiary jurisdiction, taking into account how these decisions about centralised spending impact local Beneficiary jurisdiction incentives for precautions against ex post loss. The model shows that the marginal cost of ex ante federal development spending may be greater for a Beneficiary jurisdiction than for a Contractor jurisdiction. This somewhat technical result has an observable implication: evidence that a small fraction of ex post loss in a Beneficiary jurisdiction is centrally compensated (shared across jurisdictions) is evidence that ex ante development subsidies there may be truly precautionary on net; conversely, evidence that a Beneficiary jurisdiction has a large share of its ex post hazard loss compensated by centralised disaster relief suggests that the ex ante development subsidies received by that jurisdiction did more to encourage new development and increase the amount at risk than they did to protect existing development. The model is extended to consider how ex post loss sharing impacts the demand for federally subsidised disaster insurance and other related issues.