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Fiscal Federalism and Optimum Currency Areas: Evidence for Europe from the United States

  • Sachs, Jeffrey
  • Sala-i-Martin, Xavier

The main aim of this paper is to estimate the extent to which the Federal Government of the United States insures member states against regional income shocks. We find that a one dollar reduction in a region's per capita personal income triggers a reduction in federal taxes of about 34 cents and an increase in federal transfers of about 6 cents. Hence, the final reduction in disposable per capita income is around 60 cents. That is, between one-third and one-half of the initial shock to the region is absorbed by the Federal Government. Taxes respond more strongly to regional imbalances than do transfers. The main mechanism at work is the federal income tax system, which implies that the stabilization process is automatic rather than specifically designed each time there is a cyclical movement in income. Some economists may argue that this regional insurance scheme, provided by the Federal Government, is an important reason why the US system of fixed exchange rates has survived without major difficulties. According to this view, Europeans who look to the United States as a model for Europe should seriously consider the creation (or expansion) of a federal fiscal system at the same time as they create a European Central Bank that issues a unified European currency. The creation of the latter without the insurance mechanism provided by the former could endanger the entire process of monetary unification. Approximate calculations of the impact of the existing European tax system on regional income suggests that a one dollar shock to regional GDP will reduce tax payments to the EC government by half a cent. Hence, the current European tax system has a long way to go before it reaches the 34 cents response of the US system.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 632.

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Date of creation: Mar 1992
Date of revision:
Handle: RePEc:cpr:ceprdp:632
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  1. Robert J. Barro & David B. Gordon, 1983. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
  2. Obstfeld, Maurice, 1986. "Capital controls, the dual exchange rate, and devaluation," Journal of International Economics, Elsevier, vol. 20(1-2), pages 1-20, February.
  3. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec..
  4. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, vol. 93(2), pages 223-47, April.
  5. Thomas Willett & Edward Tower, 1970. "Currency areas and exchange-rate flexibility," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 105(1), pages 48-65, September.
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