Risk diversification in federations

This paper considers a federation composed of n regions that are subject to region-specific income shocks. It examines the roles of two alternative mechanisms -- one market and one non-market -- in mitigating risk in the federation. The market mechanism diversifies risk through the credit market. The non-market mechanism is based on a federal income tax followed by redistribution of the tax revenue in lump sum fashion. Empirical literature has shown that the relative role of these two mechanisms differs across well-established federations such as USA, Canada and the European Union. This paper considers the roles of these mechanism, both in isolation and when they work in tandem, and then examines how the relative roles of the mechanisms may differ depending on the federation's size, variance of the income shocks, income of regions, the discount factor, whether income shocks are independent or correlated across regions, and whether regions in the federation are homogeneous or heterogeneous.