Risksharing within the United States: what have financial markets and fiscal federalism accomplished?

Abstract: We document aggregate income growth uncertainty at the state level, and the extent to which this uncertainty is reduced by risksharing through financial markets and federal fiscal policy. A methodology is adopted that is closely connected to the empirical growth literature. It does not rely on assumptions about a model or stochastic process of income. This is important because estimated gains from international risksharing have been found to be very sensitive to the assumed model or income process. We only make assumptions about the information set used to predict growth, which is sufficient (and necessary) to compute income growth uncertainty. Estimates of growth uncertainty for a representative state are obtained at horizons from one to twenty-six years from panel regressions of state income growth, in deviation from national growth, on variables in the information set. This \\"residual risk\\" can be fully diversified at a zero risk premium. We show that potential welfare gains from risksharing depend on a weighted average of the variance of residual risk at different horizons. Three measures of income are considered: gross state product, pre-tax state income, and disposable state income. The differences between the first two is associated with financial markets (net asset income), while the difference between the last two is associated with federal fiscal policy (federal taxes and transfers). At a 26-year horizon we find that 71% of potential welfare gains from risksharing have already been achieved; 60% through financial markets and 11% through federal fiscal policy.

Keywords: Financial markets; Fiscal policy; Risk;

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Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Research Paper

Publication Date: 1998

Number: 9808