Employing a political-economics approach, this paper comparessmall states and unions when the former fail to internalizecross-border externalities of publicly provided goods. Itdiscusses two types of unions: federations with more than onelevel of government and unitary states. While unitary statesare unable to differentiate public spending according todiffering preferences, rents of governments in a federationare higher due to a common-pool problem. The comparison leadsto the following results. (1) Citizens prefer small states tolarge states if spillover effects are weak. (2) They benefitfrom a multi-level government only if their preferencesheavily differ from the median-voter's preferences and ifspillovers are strong. Based on this comparison the paper alsodiscusses the creation of unions. Making specific assumptionon the distribution of preferences, it analyzes strong Nashequilibria at the union formation stage.
KeywordsPublic Finance Spillover Effect Union Formation Unitary State Public Spending
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