Fiscal Federalism and Capital Accumulation



This paper explores the effect of fiscal federalism on capital accumulation and growth in an overlapping-generations model. By relaxing the uniform-consumption requirement of a unitary system, fiscal federalism allows the economy to respond to a difference in public-good demands between young and old. Public-good levels and taxes move in opposite directions for the young and old as their different demands are fulfilled, and this leads to opposing changes in private-good consumption for the two groups. These changes disrupt the preferred time path of private consumption, which is restored by a change in saving. This change in turn alters the equilibrium capital intensity of the economy, and growth effects emerge during the transition to the new equilibrium.