Fiscal Federalism in Continuous Time Stochastic Economies

This paper examines the different types of incentives that countries face when deciding to take part in a federal fiscal system. The optimal degree of participation depends on the structural parameters of the economy and on the properties of the federal fiscal system. Firstly, the paper examines the case of federal fiscal systems that work as simple insurance arrangements. Secondly, a mixed insurance and redistribution system is considered. Thirdly, fiscal system participation is added as a parameter of the utility function. Finally, the paper examines the case of a fiscal federation that responds to shocks on the terms of trade. The models are developed in a continuous time stochastic framework and simple closed form solutions are obtained. Simulation methods are used to illustrate the stationary equilibrium path of variables. The paper concludes that risk sharing is a strong motive for taking part in a fiscal federation. Fiscal system participation increases when the country benefits from redistribution or when participation is a parameter of the utility function. Finally, it is shown that there are incentives to participate in fiscal federations that respond to shocks on the terms of trade. In this case, the higher the volatility of the shocks on the terms of trade, the lower the variance of the capital stock growth rate in the optimum. ∗Address: Faculdade de Economia daUniversidade Nova de Lisboa, Travessa Estêvão Pinto (Campolide), 1099-032 Lisboa, Portugal. Tel: (351) 21 383 36 24, Fax: (351) 21 388 60 73, e-mail: [email protected]. The author gratefully acknowledges the financial support from a grant of the Fundação Amélia de Melo.