Federal Transfers, Decentralization and the Labor Market

Abstract

This paper analyzes the case for fiscal federal transfers in a Monetary Union. Looking at the labor market structure, it emphasizes the incentive effect of any federal transfer scheme insuring workers against bad draws. When the wage negociation process occurs at the national level and the federal government has incomplete information on the bargaining process, workers have an incentive to ask ex-ante for higher wages. This may negatively affect the macroeconomic performance in the federation. The First Best solution consists in shifting the wage bargaining process from the national to the federal level. Decentralization of fiscal policy would solve the incentive problem. However, looking at the fiscal federalism issue, we show that it is always optimal to keep federal transfers. Moreover, decentralized policies are only effective when access to financial markets is imperfect. Thus the paper makes a strong case in favor of centralization.