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In this paper we investigate the interplay between national rainy-day funds and supra-national transfers in a fiscal union. Given that the EU has established rules limiting deficits, national rainy-day funds could in theory provide a way for countries to obey the rules and use fiscal policy, yet avoid using austerity measures during a recession. The rainy-day fund is self-insurance and we examine the funding of a national rainy-day fund for a country in isolation. We then introduce a fiscal union while allowing member countries to retain some fiscal policy control. We find that moral hazard leads to lower contributions to a rainy day fund with a fiscal union present, and further that the higher the fiscal transfer, the lower will be the contributions to the rainy-day fund. The optimal size of the fiscal union trades-off the ex-post insurance provided by the union and the moral hazard which reduces national ex-ante preparation for stabilization policies. Optimally, the insurance provided by the fiscal union should be lower (1) the more effective is own-fiscal policy; (2) the more the presence of the fiscal union reduces rainy-day fund savings; (3) the lower is the relative probability of recession; and (4) the lower is the utility gain of redistribution in the union. We also find that commitment to a transfer policy is essential. A fiscal union that is prone to break the rules on transfers negatively impacts the ex-ante contributions to individual members' rainy day funds.

This paper surveys recent research on decentralization and natural disasters. The first part discusses results from theoretical models that have been used to study the issues that arise when natural disasters occur in a country with more than one level of government. The next section discusses the empirical results that have been found in the literature. A third section briefly touches upon practical problems that arise when decentralized governments are confronted with a natural disaster. The paper concludes by reflecting on what we know about whether policies to confront natural disasters should be centralized or decentralized.

Banks and the financial sector have come under increased scrutiny since the 2008 financial crisis. Regulations concerning the banking sector have been re-written and there have been calls for increased taxation of banks (as companies) and the remuneration of bankers. In general, two sorts of taxes are commonly mentioned, taxes on the profits of banks and taxes on bank wages. As the corporate tax may be borne by labor, a natural question to ask is whether the economic incidence of these taxes really differs. The cost of regulations can also be passed on, but public finance economists typically ignore the incidence of regulations, a potentially important source of influence for banks. This paper focusses on two questions. First, we ask whether there is an earnings premium in the financial sector. Second, we examine the issue of tax and regulatory incidence by estimating the degree to which banking regulations and company taxes on banks influence wages in the banking sector. We use individual data on wages combined with data from US states on the states' tax rates and timing of regulatory changes applied to financial corporations. We find (i) a raw 45% earnings premium in the financial sector; (ii) a negative effect of corporate tax on wages in the manufacturing sector but a positive or no effect on wages in the banking sector, and (iii) lower wages in the banking sector in states that de-regulated earlier. The tax incidence result is somewhat surprising though it is consistent with Huizinga, Voget, and Wagner (2011), who find that home country corporate income taxation of foreign-source bank income is almost fully passed through to higher interest margins charged abroad. The result may have to do with specifics of the banking industry such as market power, labor mobility, or inelastic demand and elastic supply of banking services.

One of the fundamental tenets of fiscal federalism is that, absent various sorts of externalities, decentralized governments that rely on own-source revenues should be more fiscally efficient than decentralized governments that rely on grant financing. The argument relies in part on the idea that sub-national governments, being closer to the people, are more accountable to its citizens. Accountability to citizens is also important in understanding the presence of corruption in government. This suggests that the financial structure and institutions of decentralized governments can potentially influence the degree and extent of corrupt activity. Financial structures that make governments more accountable should be associated with less corruption (other things equal), while financial structures with less accountability should be associated with more corrupt activities. We develop a simple model in which the use of grants rather than locally raised taxes increases corruption. We then use a panel data set of Mexican states to study the relationship between funding sources for Mexican states and the level of corruption in those states. We find that greater use of own tax revenues lowers corruption while greater use of grants increases corruption. This suggests that expenditure decentralization that is accompanied by revenue decentralization is likely to discourage corruption while expenditure decentralization that is funded by grants tends to encourage corruption. We also find that poverty, a measure of uninformed citizens, leads to greater corruption.

Tax competition arguments suggest that governements that operate in an open economy (such as local governments) should not and will not rely on non-benefit taxes, such as the income tax. Yet we observe reliance on income taxes by local governments in many countries, and such reliance changes over ime. Evidence from a panel data set of 13 OECD countries over the period 1975-1984 suggest that competition between levels of government (resulting in a vertical fiscal externality) and between governments at the same level (resulting in a horizontal fiscal exterbality) provide some economic rationale for these changes. Moreover, the evidence indicates that the vertical and horizontal fiscal externalities interact. These results have some interesting implications for fiscal policy in the European Union, particularly as the EU continues to evolve. One implication for the EU is that enlargement that increases tax base disparities within the EU (and is not accompanied by an EU-level income tax) will tend to lower national income tax rates, although this must be qualified because it also depends on the mobility of the population. A second implication is that fiscal expansion of the EU to include an EU-level income tax may tend to lower the reliance of national government om income taxes though the vertical externality, but may also tend to equalize tax bases across countries, and so increase reliance on national income taxes though the horizontal externality.

Recent experience with disasters and terrorist attacks in the US indicates that state and local governments rely on the federal sector for support after disasters occur. But these same governments are responsible for investing in infrastructure designed to reduce vulnerability to natural and man-made hazards. This division of responsibilities - state governments providing protection from disasters and federal government providing insurance against their occurrence - leads to the tension that is at the heart of our analysis. We explore these tensions building on the model of Persson and Tabellini (1996). We show that when the federal government is committed to full insurance against disasters, states will have incentives to underinvest in costly protective measures. We then show that when the central government cannot verify state investment choices, the optimal insurance system would be designed to reward states that succeed in avoiding disasters and punish those that do not, thereby giving states an incentive to increase investment in protective infrastructure. However, this raises the question of whether the central government can credibly commit to such a scheme, and we find in a simple political model that it cannot. In our political model, the central government will decrease transfers ex-post if a state provides protective infrastructure that increases its expected uncertain income, generating a soft-budget constraint for states. This provides an additional incentive for states to underinvest in protective infrastructure. We discuss these results in light of disaster policy in the US.

This paper contributes to the small empirical literature that attempts to estimate tax reaction functions of national governments competing with other national governments. After presenting a simple theoretical model, we estimate reaction functions for European countries for a pure Nash model and for a model in which the U.S. can act as a Stackelberg leader while the European countries compete with each other in a Nash way. We initially find a positive Nash reaction function for European countries with respect to capital taxes, but no reaction with respect to labor taxes. Further investigation of the capital tax response results in our main finding, that the European countries behave as if the U.S. is a Stackelberg leader in setting corporate taxes after the U.S. 1986 Tax Reform Act but not before. We also test whether Germany or the United Kingdom played a leadership role and find that they did not. These regression results are reinforced by our Granger causality tests, and are somewhat stronger when we exclude certain tax havens. Over time, European countries seem to have become more intensely competitive with the U.S. in corporate taxes, but less intensely competitive among themselves.

Recent experience with disasters and terrorist attacks in the US indicates that state and local governments rely on the federal sector for support after disasters occur. But these same governments are responsible for investing in infrastructure designed to reduce vulnerability to natural and man-made hazards. This division of responsibilities – regional governments providing protection from disasters and federal government providing insurance against their occurrence – leads to the tensions that are at the heart of our analysis. We show that when the federal government is committed to full insurance against disasters, regions will have incentives to under-invest in costly protective measures. We derive the structure of the optimal second-best insurance system when regional governments choose investment levels non-cooperatively and the central government cannot verify regional investment choices. Normally (though not always) this will result in lower intergovernmental transfers and greater investment. However, the second-best transfer scheme suffers from a time-inconsistency problem. Ex-post, the central government will be driven towards equalizing rather than the second-best grants, which results in a type of soft budget constraint problem. Sub-national governments will anticipate this and reduce their investment in protective infrastructure even further. We discuss these results in light of recent disaster policy outcomes in the US.

As part of a process of democratization, many countries spanning Europe, Latin Amertica, Africa, and Asia are reorganizing their governments by devolving fiscal responsibility and authority to newly empowered regional and local governments. Although decentralization in each country proceeds differently, a common element tends to be an initially heavy reliance on central government grants to fund regional spending. We develop a theoretical model of regional borrowing decisions in which the incentives for regional borrowing depend crucially on how the regions expect the federal system of finance to evolve. We examine the implications of the model using data on Spanish regions for the period 1984-1995 and find evidence that regions may be borrowing inefficiently in response to incentives imbedded in the Spanish system of fiscal decentralization.