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.