DP728 Federal Fiscal Constitutions. Part I: Risk Sharing and Moral Hazard
|Author(s):||Torsten Persson, Guido Tabellini|
|Publication Date:||October 1992|
|Keyword(s):||Fiscal Federalism, Investment Subsidies, Politics, Principal-Agent Models, Risk Sharing|
|JEL(s):||D70, E15, E60, H10|
|Programme Areas:||International Macroeconomics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=728|
Inspired by current European developments, we study equilibrium fiscal policy under alternative constitutional arrangements in a `federation' of countries. There are two levels of government: local and federal. Local policy redistributes across individuals and affects the probability of aggregate shocks, while federal policy shares international risk. Policies are chosen under majority rule. There is a moral-hazard problem: federal risk-sharing can induce local governments to enact policies that increase local risk. We investigate this incentive problem under alternative fiscal constitutions. In particular, we contrast a `horizontally-ordered' federal system like the United States (in which the federal government deals directly with individuals) with a `vertically-ordered' system like the EC (in which the federal government deals with national states). These alternative arrangements are not neutral, in the sense that they create different incentives for policy-makers and voters, and give rise to different political equilibria. A general conclusion is that centralization of functions and power can be welfare improving under appropriate institutions. This conclusion only applies, however, to the moral-hazard problem and a federation where the countries are not too dissimilar.