Greco L. (2008).

Asymmetric Information and Regional Transfers: Federalism versus Devolution. The Icfai Journal Of Public Finance, vol. VI, p. 29-48

 

Abstract:

Intergovernmental transfers under asymmetric information have been analyzed basically through adverse selection models. This setting fits well in the stylized facts of consolidated federalism, though it is unsatisfactory to analyze the recent devolution of fiscal powers. In the latter case, the fundamental informational asymmetry between central and local governments is related to the imperfect verifiability of local policies. The paper shows that, whatever the institutional setting, asymmetric information reduces the scope for interregional equalization. However, the sign of optimal distortion that grants bring about on regional fiscal policy may differ between federalism (adverse selection) and devolution (pure moral hazard).

Intergovernmental fiscal relations is a traditional topic in economics (Inman and Rubinfeld, 1997; and Oates, 2000). In the symmetric information framework characterizing the traditional literature on fiscal federalism, transfers are devised either as matching grants, compensating for fiscal externalities, or as lump sum grants, equalizing tax bases, public needs and production costs. The traditional view has been challenged during the last two decades. The starting point of the new theoretic approach is the recognition that fiscal relations in a multi-tier public sector are characterized by asymmetric information.

The basic idea of the new approach is that local governments have better information about the status of the actual social and economic fundamentals (e.g., aggregate production, average individual revenues, aggregate tax base, poverty rate, etc.) of their jurisdiction with respect to central authorities. Moreover, central government is unable to verify the actual structure of local policies. Asymmetric information creates a scope for opportunistic behavior on the part of the local governments, thus a trade-off between efficiency and distribution arises.