Federal systems are often more sophisticated than assumed in the literature. In many cases, at least three tiers of government are involved in federal decision making. The purpose of this paper is to cast some light on this increasingly important issue in fiscal federalism.
In a model with three tiers of government, the author analyzes corrective policies in the presence of fiscal externalities generated by federal redistribution.
The author identifies an additional qualitative incentive effect, particularly for intermediate governments. They behave strategically to attract additional redistribution funds from outside, though still using corrective policies to provide investment incentives toward their own regions. The results also suggest that differently from the USA the federal system of the EU may lead to inefficiently low regional investment.
The presented model is a first step toward analyzing strategic behavior and the effect of corrective policies in more complicated federal set ups with three tiers of government involved. This is relevant for federal structures such as Germany or the USA, as well as for government interactions at the international level.
JEL Classifications — E62, H77, F02
The author is grateful to Maarten Allers, Thiess Buettner, Jin Cao, Andreas Haufler, Rainer Lanz, Marco Runkel, Chen Zhao, and seminar participants at Munich University (LMU), the European Investment Bank and the IIPF conference, Warwick (2007), for many inspiring discussions and hints. Financial support from the German Research Foundation (DFG) is gratefully acknowledged. Opinions expressed in this paper are those of the author. They do not necessarily reflect the views of the OECD.
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