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The Optimal Design of a Fiscal Union

We study cooperative and non-cooperative fiscal policy in a multi-country model where asset markets are segmented and countries face terms of trade externalities. We show that the optimal form of fiscal cooperation, or fiscal union, is defined by the Armington elasticity of substitution between the products of different countries. We prove that members of a fiscal union should: (1) harmonize tax rates when the Armington elasticity is low in order to ameliorate terms of trade externalities; and (2) send fiscal transfers across countries when the Armington elasticity is high in order to improve risk-sharing. For standard calibrations, the welfare gains from tax harmonization are as high as 0.3% of permanent consumption for countries both inside and outside of a currency union. The welfare gains from fiscal transfers are close to zero for countries outside of a currency union, but rise to between 0.5% (France) and 3.6% (Greece) of permanent consumption for countries inside a currency union.