Browsing by Person "Kraft, Julius"

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Macroeconomic aspects of fiscal federalism in monetary unions
(2025) Kraft, Julius; Evers, Michael
There is an ongoing policy debate about federal fiscal structures in the European monetary union, that has recently gained new momentum in context of the Recovery and Resilience Facility within the Next Generation European Union programme as well as the reform of the Stability and Growth Pact within the European fiscal framework. This long-standing debate, that originates from the European unification process, has thus far led to a monetary union without a complementary fiscal union. The recent reforms once again raise the question of the desirable degree of federal integration and the optimal design of fiscal institutions in the European monetary union. This thesis assesses the macroeconomic characteristics of different federal fiscal arrangements, common debt structures and risk-sharing mechanisms in a monetary union and derives policy implications for the ongoing debate about fiscal federalism in the European monetary union. The integration of strategically interacting regional fiscal authorities into a structural two-country model of a monetary union allows to quantitatively assess their strategic incentives and the resulting business cycle and welfare effects. Introducing different federal fiscal arrangements and common debt structures to the monetary union yields insights about the resulting incentive effects as well as their macroeconomic consequences. In particular, the analysis focusses on the macroeconomic characteristics of a fiscal equalisation mechanism, a central fiscal authority, a debt rule and common debt in a monetary union. From an empirical perspective, an agnostic orthogonalisation approach is suggested, that allows to decompose the business cycle shocks in the Euro area into their common and idiosyncratic shock components. Analysing their empirical characteristics yields insights about the scope for macroeconomic risk-sharing across the countries of the Euro area. The first chapter identifies the strategic incentives for the regional fiscal authorities in a monetary union to adjust their labour income tax responses and quantifies the resulting business cycle and welfare implications. There is a general trade-off between the adverse incentives for strategic behaviour and the allocative efficiency, so that strategic interac tion results in inefficient allocations and causes welfare losses. Building upon the fiscally decentralised benchmark economy with standard economic frictions, a fiscal equalisation mechanism and a central fiscal authority are introduced to the monetary union. Whereas the regional fiscal authorities have strategic incentives for stronger labour income tax responsiveness to changes in the tax base and the debt-to-GDP ratio than efficient in the benchmark economy, their responses are weaker than efficient with a central fiscal authority. In the presence of strategic interaction, introducing a central fiscal authority improves welfare, whereas a fiscal equalisation mechanism causes welfare losses relative to the benchmark scenario. The second chapter analyses the impact of different common debt regimes and potential adverse strategic incentives within a monetary union. The common debt structures encompass a debt-unrestricted benchmark, a debt rule set-up, and a common debt scenario. Labour income taxation, as the strategic fiscal policy instrument, responds to labour income as the tax base and the regional debt-to-GDP ratio through a feedback rule. The benchmark scenario reveals existing adverse effects from the strategic use of labour income taxation for the regional benefit. This scenario serves as a point of comparison for the optimal labour taxation in the other two common debt regimes. A Nash equilibrium is used to evaluate this strategic component of taxation. The strategic tax component leads to inefficiently high tax rates that require internalisation through different debt structures. In the absence of model frictions such as nominal rigidities and distortionary taxes, the debt rule scenario internalises the inefficiency of the debt effect. In contrast, the common debt case internalises the strategic tax base effect. Taking all frictions into account, both debt scenarios lead to lower and more efficient tax rates, which demonstrates the internalisation of the strategic component. The debt rule and the common debt structure lead to welfare gains compared to the benchmark scenario, both with and without strategic incentives. In addition, these arrangements can mitigate the trade-off between strategic incentives and the allocative efficiency. Especially in the common debt case, the strategic incentives are almost internalised through the additional risk-sharing mechanism. The third chapter decomposes the business cycle shocks in the Euro area into their common and idiosyncratic shock components to evaluate the scope for macroeconomic risk-sharing across countries. The approach is based on the Aoki (1981) transformation, that allows for an agnostic orthogonalisation of the shock components that is independent from structural assumptions. An application to the core and the periphery of the Euro area shows that the cyclical fluctuations are heterogeneous between these groups of countries. Since common shocks explain most of the region-specific shock variance, their shocks are nevertheless highly correlated. Extending the analysis to the initial Euro area countries, the results show that the common shock component explains most of the country-specific shock characteristics and that the idiosyncratic component is relatively less relevant. A risk-sharing mechanism for idiosyncratic shocks has the potential to reduce fluctuations in all Euro area countries, whereas an equalisation of the weighted cyclical differences can even be counter-productive and increase the business cycle fluctuations in some countries. The strategic interaction between the regional fiscal authorities in a monetary union has substantial incentive effects with considerable business cycle and welfare implications. There is a general fiscal policy trade-off between the adverse incentives for strategic behaviour and the allocative efficiency, so that strategic interaction results in inefficient allocations and causes welfare losses. It is demonstrated in how far different publicly discussed federal arrangements and common debt structures internalise the strategic externalities resulting from fiscal policy spillovers. In general, federal integration in a monetary union increases the strategic externalities, so that the adverse incentives are overall weaker. In principle, there is potential for welfare improvements through the coordination of strategic fiscal policies. Given that adverse incentives already exist within the current European fiscal framework, any attempt to internalise the strategic externalities through the federal structure has the potential to generate welfare improvements. However, the estimated scope for macroeconomic risk-sharing across the Euro area countries is limited since common shocks are predominant. Nevertheless, a risk-sharing mechanism for idiosyncratic shocks has the potential to reduce the cyclical fluctuations in all Euro area countries, thereby contributing to the convergence towards a common business cycle.