1995 Reports

Capital Mobility and the (In)efficiency of Fiscal Unions

Perotti, Roberto

Several countries in all parts of the world are undergoing a process of integration, several others are experiencing strong pressures towards increasing decentralization. At the same time, many of these countries are struggling to control the expansion of redistributive expenditures and their distortionary effects on the allocation of resources. Therefore, a fundamental question in all these countries is what is the allocation of tasks to different levels of governments that best controls social expenditure and minimizes distortions. Because these processes occur within or between economies with high capital mobility, a second crucial question is therefore what are the effects of capital mobility on the budget size and productivity efficiency under different fiscal policy arrangements. This paper develops a two-country model where redistribution is determined endogenously through a voting process, and argues that a decentralized regime is likely to minimize the distortionary effects of redistribution. Surprisingly, capital mobility exacerbates the inefficiency of the centralized regime. First, capital mobility increases the distortionary effects of redistribution in the economy; second, once the choice of the regime too is endogenized, it causes a majority of individuals in both countries to choose the more inefficient regime. The paper also highlights the importance of considering specific institutional aspects of redistribution, the tax system and labour markets. An important message of the model is that a process of fiscal integration may lead to "bad" outcomes when it involves countries with very different institutional characteristics.