Idiosyncratic and Aggregate Risk in the Presence of Government's Moral Hazard

Fiscal policy and taxation in particular play an important role in the insurance of local agents against income fluctuations. Government's power to impose taxes is a key tool for optimal redistribution among residents. And, since public debt represents future local tax income, fiscal policy also plays a role in the international risk sharing. I find that government's moral hazard introduces a trade-off between pooling idiosyncratic risk and diversifying aggregate country uncertainty. As a result, local agents face excessive consumption risk. This paper also explores how institutions can be designed as to overcome this moral hazard problem.