Optimal taxation and risk-sharing arrangements in an economic federation

This paper analyzes optimal taxation and risk-sharing arrangementsin an economy with two levels of government. Both levels providepublic goods and finance their expenditures via labor incometaxation, where the tax base is responsive to the private agents'labor supply decisions. The localities are assumed to experiencedifferent random productivity shocks, meaning that the privatelabor supply decision as well as the choices of income tax ratesare carried out under uncertainty. Part of the central government'sdecision problem is then to provide tax revenue sharing betweenthe local governments. The optimal degree of revenue sharingdepends on whether or not the localities/regions differ withrespect to labor supply incentives.