“Theory of Optimal Fiscal Unions” by Jan Fidrmuc
I propose a political-economy model of optimal fiscal unions where the threat of secession imposes a limit on fiscal redistribution between regions. Fiscal transfers take place indirectly, through centralized fiscal policy. I argue that the stability of fiscal unions depends on the nature of economic shocks. My analysis thus presents a fiscal-federalism counterpart to the theory of optimum currency areas. However, I show that both the correlation of shocks across regions and their persistence over time are important. Negatively correlated temporary shocks allow greatest gains from inter-regional risk sharing and therefore asymmetric shocks need not threaten the stability of integration.