Horizontal versus vertical fiscal equalization: the assignment problem

Abstract

We analyze a model in which the central government can establish a vertical equalization scheme, whereas the regional governments can set up a horizontal equalization scheme. The two levels of government decide in different chronological order. It turns out that, regardless of the timing, the central government always prevails—horizontal equalization does not take place. However, the subgame-perfect equilibrium is only Pareto-efficient, if the central government acts as a Stackelberg leader. Moreover, if the goal of achieving equality in living conditions across the regions is pursued in the model economy, the only suitable candidate for reaching this goal is vertical equalization.