The paper studies the design of optimal fiscal rules for members of a monetary union when there are privately observed shocks to countries’ social cost of domestic taxation. First, I show that optimal fiscal rules prescribe policy coordination in the sense of domestic taxation efforts that are positively correlated across member countries. In particular, coordination achieves higher ex-ante joint welfare than any fixed upper bound on domestic deficits. Second, I show that a history of asymmetric domestic taxation efforts leads to tighter policy coordination in the sense of an emergence of retaliatory fiscal policies. As a result, past disagreement leads to an increase in expected domestic deficits across the monetary union.
