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Does EMU Need a Fiscal Federation ? 1

The stabilization provided by the US federal budget has been used as an example of the adjustment mechanisms that are lacking in Europe and which are needed to make a currency area viable. This paper presents four sets of findings that suggest that the benefits of a European fiscal federation would be modest. First, we show that some of the previous estimates of the benefits of the US federal budget overestimate the amount of interstate insurance by a factor of 3. Second, Europe already has national tax systems which, according to our estimates, can insure more than 50% of a European fiscal federation. Third, we find evidence that the potential insurance benefits of a European fiscal federation have decreased over time. Fourth, there are large cross-country differences in the benefits provided by the federation. We conclude that the potential to provide interregional insurance by creating a European fiscal federation is too small to compensate the many problems associated to its design and implementation.