Optimal taxation and risk-sharing arrangements in an economic federation

This paper analyzes optimal taxation and risk-sharing arrangements in an economy with two levels of government. Both levels provide public goods and Þnance their expenditures via labor income taxation, where the tax base is responsive to the private agents’ labor supply decisions. The localities are assumed to experience different random productivity shocks, meaning that the private labor supply decision as well as the choices of income tax rates are carried out under uncertainty. Part of the central government’s decision problem is then to provide tax revenue sharing between the local govern- ments. The optimal degree of revenue sharing depends on whether or not the localities/regions differ with respect to labor supply incentives. Keywords: Optimal taxation, multilevel government, Þscal externalities, uncertainty, risk-sharing. JEL classiÞcation: D61, D62, D80, H21 ,H 71. The authors would like to thank Timothy Goodspeed, Karl-Gustaf L¨ofgren and Oved Yosha for helpful comments,and suggestions. A research grant from the Swedish Association of Local Authorities (Kommunf¨orbundet) is gratefully acknowledged. 1