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The Optimal Design of a Fiscal Union

  • Jonathan Hoddenbagh
  • Mikhail Dmitriev

We study cooperative and non-cooperative fiscal policy in an open economy model where cross-country risk sharing is imperfect and countries face terms of trade externalities. We show that the optimal form of fiscal cooperation, or fiscal union, is defined by one parameter: the Armington elasticity of substitution between goods from different countries. We prove that members of a fiscal union should: (1) harmonize steady state income tax rates when the Armington elasticity is low in order to ameliorate terms of trade externalities; and (2) send fiscal transfers across countries when the Armington elasticity is high in order to improve risk sharing. Our analytical predictions hold both outside of and within currency unions. For standard calibrations, we find that the welfare gain from the optimal fiscal union is as high as 5% of permanent consumption when countries are able to trade safe government bonds, and can approach 20% when countries lose access to international financial markets. We also find that labor mobility significantly improves welfare and alleviates the need for a transfer union entirely.

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Paper provided by Job Market Papers in its series 2013 Papers with number pho497.

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Date of creation: 14 Nov 2013
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Handle: RePEc:jmp:jm2013:pho497
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  1. Imbs, Jean & Mejean, Isabelle, 2009. "Elasticity Optimism," CEPR Discussion Papers 7177, C.E.P.R. Discussion Papers.
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  4. Dmitriev, Mikhail & Hoddenbagh, Jonathan, 2012. "Price Stability In Small Open Economies," MPRA Paper 46132, University Library of Munich, Germany, revised Feb 2013.
  5. repec:oup:restud:v:72:y:2005:i:3:p:707-734 is not listed on IDEAS
  6. Ferrero, Andrea, 2005. "Fiscal and monetary rules for a currency union," Working Paper Series 0502, European Central Bank.
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  14. Robert C. Feenstra & Philip A. Luck & Maurice Obstfeld & Katheryn N. Russ, 2014. "In Search of the Armington Elasticity," NBER Working Papers 20063, National Bureau of Economic Research, Inc.
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  19. Barry Eichengreen & Fabio Ghironi, 2002. "Transatlantic Trade-Offs in the Age of Balanced Budgets and European Monetary Union," Open Economies Review, Springer, vol. 13(4), pages 381-411, October.
  20. Simonovska, Ina & Waugh, Michael E., 2014. "The elasticity of trade: Estimates and evidence," Journal of International Economics, Elsevier, vol. 92(1), pages 34-50.
  21. Emmanuel Farhi, 2013. "Fiscal Unions," 2013 Meeting Papers 194, Society for Economic Dynamics.
  22. John Romalis, 2007. "NAFTA's and CUSFTA's Impact on International Trade," The Review of Economics and Statistics, MIT Press, vol. 89(3), pages 416-435, August.
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  24. Evers, Michael P., 2012. "Federal fiscal transfer rules in monetary unions," European Economic Review, Elsevier, vol. 56(3), pages 507-525.
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