Federal Fiscal Constitutions. Part I: Risk Sharing and Moral Hazard

Torsten Persson () and Guido Tabellini

No 728, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: 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.

Keywords: Fiscal Federalism; Investment Subsidies; Politics; Principal-Agent Models; Risk Sharing (search for similar items in EconPapers)
JEL-codes: D70 E60 H10 (search for similar items in EconPapers)
Date: 1992-10
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Citations: View citations in EconPapers (13)

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Related works:
Working Paper: Federal Fiscal Constitutions; Part I: Risk Sharing and Moral Hazard (1993)
Working Paper: Federal fiscal constitutions part 1: risk sharing and moral hazard (1992)
Working Paper: Federal Fiscal Constitutions; Part I: Risk Sharing and Moral Hazard (1992)
Working Paper: Federal Fiscal Constitutions. Part I: Risk Sharing and Moral Hazard
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