FEDERAL FISCAL CONSTITUTIONS - RISK SHARING AND MORAL HAZARD

We study the collective choice of fiscal policy in a ''federation'' wi th two levels of government. Local policy redistributes across individ uals and affects the probability of aggregate shocks, whereas federal policy shares international risk. There is a tradeoff between risk-sha ring and moral hazard: federal risk-sharing may induce local governmen ts to enact policies that increase local risk. We analyze this tradeof f under alternative fiscal constitutions. In particular, we contrast a vertically ordered system like the EC with a horizontally ordered fed eral system like the US. Alternative arrangements create different inc entives for policymakers and voters, and give rise to different politi cal equilibria. Under appropriate institutions, centralization of func tions and power can mitigate the moral hazard problem.