EMU's Decentralized System of Fiscal Policy



payroll taxes which are often declared and paid with delays. To set up such a mechanism,
member countries of the euro area could agree to share a portion of their VAT revenues
through the common fund. In fact, different countries could participate in such a fund with
different shares of their VAT revenues according to national preferences and economic
circumstances. For example, governments with more volatile economies could decide to bring
a larger share of their revenues into the fund. Implementation of such a mechanism would,
therefore, not require raising VAT rates in any member state, an important condition for the
acceptability of the proposal.

An advantage of such a mechanism is that it would allow member governments to engage in
counter-cyclical policies addressing asymmetric shocks in a way fully consistent with the
rules of the SGP. States receiving net transfers could increase government spending without
violating their commitment to keeping their budgets close to balance or in surplus. Note that
the additional spending should have a greater effect on aggregate spending in the country
concerned, as households would recognize that it is not connected with an increase in future
tax liabilities and, hence, would not cut back private demand as in the case of deficit-financed
government spending; a point confirmed empirically by Bayoumi and Masson (1995).

Assume, first, that the mechanism does not have to achieve balance at the aggregate level.
Effectively, it would then compensate the restrictions on borrowing at the national level by
allowing borrowing at the level of the euro area. A strict control of the mechanism assuring
that it does not build up a stock of permanent debt would be required; we return to this issue
in the next section. The main moral hazard problem here is that governments would not adjust
spending in accordance with the net transfers they pay or receive under the mechanism, and,
thus, not provide the desired stabilization. But this problem need not worry the euro area as a
whole. It could be left up to the national electorates to make sure that their governments use
the resources they have available properly.

Things are more complicated if the mechanism had to be balanced financially, because it
would then have to be combined with permanent transfers among the governments
compensating for differences in their risk profiles. Negotiating these transfers and adjusting
them over time would require a way to reveal the true degree of risk aversion of the national
populations and the true volatility of the asymmetric shocks. Both would be difficult to
achieve and subject the mechanism to political games. Since governments with less volatile
economies would receive permanent transfers under such a scheme, the mechanism would
create incentives to implement policies at the national level that reduce the national
economies’ exposure to asymmetric shocks. Thus, the incentive effects would work in the
direction of reducing asymmetric shocks in this case.

4.3.2. Euro-Area Unemployment Insurance

The alternative proposal would be to implement a euro-area wide unemployment insurance.
Under such a scheme, households in economies enjoying positive asymmetric shocks would
pay rising insurance contributions which would be paid to households suffering from negative
asymmetric shocks. This would help stabilize aggregate demand across euro-area countries.
Since unemployment insurance would constitute an entitlement for individuals, such a
scheme cannot be forced to balance at the aggregate level unless the governments pay
additional contributions making good for any shortfalls of revenues over expenditures.17

An insurance mechanism of this sort would have to address a variety of problems. First, given
that levies on labor income are large in most European countries already, it would have to be

17 This system would differ from European regional policies since these policies involve transfers based
on income levels, not cyclical fluctuations.

15



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