Fiscal Federalism, Risk Sharing and the Persistence of Shocks

When individuals are risk adverse, they dislike volatility in consumption. In an environment where economic fluctuations are driven by exogenous real shocks, governments try to prevent these exogenous real shocks from inducing consumption volatility. Taking the process that determines these exogenous fluctuations as given, there are two methods through which the government can intervene and prevent excessive consumption volatility. They can use the various tools of government, like monetary policy or government consumption, to smooth aggregate demand and aggregate output in the face of these exogenous shocks. Similarly they can allow fluctuations in output, but use fiscal policy through direct taxes and transfers to smooth any consumption fluctuations. It should be clear from the title that this paper will focus on the latter method. In a currency union like the euro zone, individual national governments ceded their national monetary policies to the European Central Bank. Thus individual governments in the euro zone no longer have monetary policy as a tool to prevent country-specific real shocks from driving fluctuations in country-specific output. As will be clear in a later section, this paper will not model the role of government consumption in smoothing output fluctuations (see Fatás and Mihov 1999, for a discussion on the output stabilizing role of government spending). Instead this paper will focus on the role of a government tax and transfer scheme in smoothing consumption fluctuations given fluctuations in output.