Devolution in the Provision of Merit and Impure Public Goods: Who Gains, Who Loses

Abstract

In this article we propose a model that explains why devolution in the real world may be implemented even when efficiency would call for a centralised solution. In a context where Central Government delegates to lower tiers the provision of merit and impure public goods, fiscal federalism has particular characteristics that have not received due attention: (i) the equalisation grant which plays a crucial role; (ii) cross border provision which gives rise to financial agreements that need to be regulated. In a context of full information and in a setting where the traditional benefi ts arising from fiscal federalism are ignored, our model shows that fiscal federalism, although sub-optimal for the whole community, may be welfare improving for the richest local authority because it reduces the amount of the equalisation grant.