Inspired by the 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 the local governments to enact policies that increase local risk. We investigate this incentive problem under alternative fiscal constitutions. In particular, we contrast a vertically ordered system like the EC with a horizontally ordered federal system like the US. These alternative arrangements are not neutral, in the sense that they create different incentives for policymakers 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. However, this conclusion only applies to the moral hazard problem and a federation where the countries are not too dissimilar.
- Federal Reserve Bank of Minneapolis. Research Department.
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