Modeling fiscal federalism: A decomposition analysis of changes in intra-European Union budgetary transfers

We use a stylized model of inter-governmental transfers to investigate the extent to which the post-Maastricht increase in the European Union budget, and the associated increase in net transfers among the member states, has been driven by the political deepening of the European Union. We find that only two-thirds of the increase in net transfers is attributable to the increased cohesion of the Union. The remainder is due to the entry of Austria, Finland, and Sweden and changes in the relative population of member states. We also find that the convergence in member states' per capita incomes, measured in inflation-adjusted local currency, has been almost entirely offset by the devaluation of the currencies of poorer member states. Therefore, relative income considerations have played no role in the change of net transfers. The methodology introduced in this paper is of general applicability to a large number of federations.