Economic Risk and Political Risk in Fiscal Unions, Issue 4992
National Bureau of Economic Research, 1995 - Fiscal policy - 24 pages
A fiscal program that redistributes income from rich to poor individuals indirectly redistributes tax revenues from regions hit by a favorable shock to regions hit by an unfavorable one. Centralized fiscal redistribution has therefore been advocated as a way to insure individuals against region-specific shocks. In this paper, we argue that a centralized fiscal policy, while reducing the uncertainty on the tax base, creates uncertainty on the tax rate. This occurs because regions hit by different shocks have contrasting interests on the choice of the policy instrument. Using a simple model with two regions and linear taxes, we show that the higher uncertainty on the policy instrument might more than offset the lower uncertainty on the tax base, thus making a majority of agents in each region worse off in a centralized regime. The model is a special case of a more general idea. Heterogeneous entities can reap numerous advantages from integration: mutual insurance (on which we focus), economies of scale, more bargaining power are only a few of them. However, at the same time the same process of integration can increase the unpredictability of any endogenous policy, because more diverse entities participate in the decision-making process, and therefore the opportunities for disagreement increase. In principle, this second effect might offset the advantages of integration.
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after-tax earned income agent of type Alberto Alesina analytical solution assumption average income average tax rates centralized fiscal policy centralized regime centralized tax rate component constant relative risk countercyclical country-specific shocks decentralized regime distribution of endowments distribution of income E(Uc(tc E(Ud(td economic risk utility equilibrium tax rate expected tax rates expected utility expected value gopher at nber.harvard.edu high values higher political risk individual prefers individuals of type inequality 9 integration labor low values lucky country Macroeconomics majority of agents majority of individuals median voter member of group mutual insurance NBER Working Papers negative Papers and Reprints parameter values polarized distribution policy instrument political jurisdictions positive pre-tax income prefer the centralized prefer the decentralized program that redistributes Proposition range of parameter redistributes income redistributive fiscal policy relative risk aversion risk and political risk aversion increases risk utility differential solid line tax base trade-off Type-A individuals uncertainty variance