Fiscal Federalism
Risk-sharing

Discussion since Maastricht has focused on three main macroeconomic policy issues: how to assign policy implementation among different levels of government; how to appoint central policy-making bodies and how to make them politically accountable; and the appropriateness, design, regulation and operation of a Community-level scheme to compensate for governments' reduced ability to cushion shocks at the national level.

In Discussion Paper No. 728, Research Fellows Torsten Persson and Guido Tabellini assume risk-averse individuals living one period with identical consumption preferences and `random' income depending on common and individual-specific factors, and policy chosen under majority rule, to compare different types of federal institutions (the EC and US) and the varying levels of moral hazard inherent in risk-sharing arrangements. `Policy' includes `social insurance', to redistribute consumption among `lucky' and `unlucky' individuals, and `public investment' of resources.

They find first that precedence to federal policy mitigates the incentive problem; second, centralizing some social insurance at the federal level can be welfare-improving; third, centralization of public investment also reduces moral-hazard problems. This casts some doubt on the `subsidiarity principle', by emphasizing the spillover effects of one policy on incentives in other areas of policy-making. Persson and Tabellini conclude that centralizing tasks and power from the local to the federal level is efficient, but they stress that a formulation that stresses incentive problems at the central level of government might well produce opposite conclusions.

Federal Fiscal Constitutions. Part I: Risk Sharing and Moral Hazard
Torsten Persson and Guido Tabellini

Discussion Paper No. 728, October 1992 (IM)