Inter-temporal fiscal equalization and per capita output in a federation

Abstract

We develop a model of a federation with two heterogeneous states which participate in an Australian-style inter-temporal revenue sharing-equalization scheme that redistributes income from rich to poor states. We then consider a policy shock requiring the states to make the transition to a steady state with a higher capital to effective labour ratio. It is shown that equalization induces the states to delay convergence, resulting in unambiguously smaller per capita output over time in each state, including the poor state receiving a net transfer. The paper also provides the foundation for further theoretical and empirical research.