Introduction

States participating in a federation can increase their welfare by mutually insuring idiosyncratic output risk. Such insurance can be obtained through transactions on capital markets, through cross-border ownership of productive assets, or via the tax-transfer system of the central government of the federation. Asdrubali, Sφrensen, and Yosha (1996) quantified the relative importance of the main channels through which risk sharing occurs among the 50 U.S. states. They found that when the United States is viewed as one integrated market, 39% of shocks to gross state product are insured, on average, by capital markets, and 13% are insured by the federal tax-transfer system. Further consumption smoothing through saving and dis-saving smooths 23% of shocks to output (about half of the uninsured component of income), and 25% of shocks are not smoothed.

In this chapter we investigate in greater detail the channels through which the federal government provides income insurance to U.S. states. In particular, we focus on federal taxes and transfers (e.g., unemployment contributions and benefits) and grants to states. Interest in the insurance role of central fiscal institutions has increased in recent years because of the debate on the European Monetary Union (EMU). In the absence of mechanisms for achieving income insurance and consumption smoothing, countries in recession will have an incentive to leave that union. It is often claimed that cross-country income insurance provided by central fiscal institutions is essential for the stability of a monetary union.