This paper examines how sequential decision-making by two levels of government can result in fiscal imbalances. Federal–regional transfers serve to equalize the marginal cost of public funds between regions hit by different shocks. The optimal transfers minimize the efficiency cost of taxation in the federation as a whole. The analysis shows how the existence of vertical fiscal externalities, leading regional governments to overprovide public goods, can induce the federal government to create a fiscal imbalance by selecting transfers that differ from the optimal ones. When the federal government can commit to its policies before regional governments select their level of expenditures, the fiscal imbalance will generally be negative. In the absence of commitment, the equilibrium transfer is unambiguously larger than the optimal fiscal gap, resulting in a positive fiscal imbalance.
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