We study how labor mobility affects optimal transfers in a federation and the fiscal imbalances that arise because of constraints on federal tax-transfer policies. Fiscal imbalance — a deviation from the optimal fiscal gap — occurs when the second-best allocation of resources in a federation cannot be achieved because fiscal transfers do not or cannot undo fiscal externalities among regional and federal governments. Under reasonable circumstances, we find that labor mobility increases the optimal fiscal gap, that is, increases the transfers required to achieve the second-best optimum. In a decentralized federation, the optimal fiscal gap cannot be achieved. In the absence of labor mobility, vertical fiscal externalities will apply. Regional governments will overspend, which will induce the federal government to create a negative fiscal imbalance to contain the size of its tax rate, assuming it can commit to future transfers. If the federal government cannot commit, regions will overspend even more and federal transfers will be excessive, leading to a positive fiscal imbalance. In both cases, mobility of labor mitigates the fiscal imbalance by reducing the tendency of regions to overspend.
