Abstract
How should a fiscal union be designed in order to optimally balance fiscal discretion and fiscal discipline? This question is addressed in a model where regions privately observe shocks to their respective desired fiscal policy but cannot achieve it unilaterally due to tax competition across regions. I show that regions can increase fiscal discretion by sharing tax revenue within a fiscal union. However, due to the informational asymmetry across regions, fiscal policy must be coordinated to ensure fiscal discipline. The first main result is that regions receive more insurance against common than against idiosyncratic shocks. The second main result is that past net contributors enjoy increased discretion and get to discipline past net recipients with state-contingent wasteful spending. This creates fiscal cycles in the form of predictable restrictions of tax competition.
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