Federal Fiscal Constitutions: Risk Sharing and Moral Hazard

by

Torsten Persson and Guido Tabellini

Abstract

We study the collective choice of fiscal policy in a "federation" with two levels of government. Local policy redistributes across individuals and affects the probability of aggregate shocks, whereas federal policy shares international risk. There is a tradeoff between risk-sharing and moral hazard: federal risk-sharing may induce local governments to enact policies that increase local risk. We analyze this tradeoff under alternative fiscal constitutions. In particular, we contrast a vertically ordered system like the EC with a horizontally ordered federal system like the US. Alternative arrangements create different incentives for policymakers and voters, and give rise to different political equilibria. Under appropriate institutions, centralization of functions and power can mitigate the moral hazard problem.

Keywords: fiscal federalism, constitutions, risk sharing, principal agent models.