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externalities between members of the Union, as well as a common exposure
to an increasingly integrated economy (Adsera and Boix
2002
), create incen-
tives toward pooling risks via some common fiscal institution, whereas signif-
icant disparities in income, risks, and shares of dependent population prevent
the adoption of a fully integrated system of interpersonal redistribution. This
creates a dilemma for member states in that failing to respect fiscal policy
autonomy of constituent units and failing to cope with the externalities derived
from market integration both jeopardize the existence of the economic union
itself.
Under such conditions, the solution envisioned by “functional” theories of
federalism, namely an initial phase of fiscal integration to overcome transac-
tion costs followed by a process of functional adaptation to different needs, is
unlikely to emerge.
6
Instead, a set of rather sticky domestic systems of redis-
tribution and insurance limit the available strategies to cope with the risks and
fears brought along by the process of market integration. Put simply, efforts
concentrate on bridging resource capabilities across local governments, as
opposed to income among citizens. The key intuition behind this expectation is
that, in the context of a very heterogeneous economic geography, richer regions
have a political incentive to transfer resources to poorer ones precisely to “pro-
tect” the specificities of their local political economies from a potential unde-
sired inflow of dependents or labor surplus. The incentive works as follows.
An undesired inflow of immigrants would reduce the tax base and increase
the preferred level of redistribution. More poor people implies lower contribu-
tions and higher demand for welfare. At the extreme, if levels of inequality in
the rich region overcome those of the union, a decentralized system of redis-
tribution becomes too costly. As a result, rich regions, especially those that
are also economically specialized, would benefit from reacting to the possi-
bility of an unwanted inflow of dependents before it actually happens. The
issue at stake is how to contain the amount of risk-sharing between regions,
such that fiscal centralization remains an unwanted option. To prevent such a
6
Standard economic treatments would suggest that, insofar as social policy operates as an insur-
ance mechanism that plays an important role in the functioning of efficiently designed labor
markets, the mismatch between an integrated European market and a fragmented system of
social protection is a short-term anomaly, bound to be eliminated by the passing of time.
Cassella's work relates the design of public good provision in integrated markets to issues of
allocative efficiency (Casella
2005
; Cassella and Frey 1992; Cassella and Weingast 1995). In her
view, as markets begin to integrate, centralized institutions are necessary to overcome transac-
tion costs. As markets integrate more deeply, the boundaries for the provision of public goods
must be redrawn to ensure a more efficient provision or a wider range of public goods. In light
of this argument, and to the extent that public social insurance can be considered a public good,
social policy integration should accompany market integration in the early stages, only to be
decentralized again once the design of the union requires fine-tuning. Functionalist and neo-
functionalist interpretations of European regional integration argue along similar lines. Mattli
points out that “economic integration is likely to raise questions as to how the winners will
compensate the losers. The ensuing need for compensatory mechanisms is bound to widen the
fiscal responsibility of the central authority in a region.” (1999: 39).
