Currency Pegs and Fiscal Federalism
This paper studies the different economic configurations that may give rise to incomplete fiscal decentralization, with the vertical imbalance problem associated to it. Particularly, we look at an economy which has given up monetary policy and cannot monetize national or sub-national government deficits. The question is whether dollarization is a commitment enough to discipline sub-national governments. Do incentives for Central Government bailouts disappear with dollarization? Does incomplete fiscal decentralization arises in equilibrium? We obtain two different sets of equilibria as result of a game between national and sub-national governments according to the difference parameter configuration. In one of them the Central Government will give taxing autonomy to the sub-national governments while in the other it will keep the taxing authority because it is optimal to do so. In this sense, the economy gets stuck in an inefficient level of fiscal decentralization. The model may apply to economies like Argentina, Ecuador, the CFA in Africa and Eastern European countries willing to join the Euro.
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