Economic Risk and Political Risk in Fiscal Unions

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.