Inter-regional insurance

Abstract

This paper considers the problem facing a central government which can insure regional governments (by use of intergovernmental grants) against region-specific and privately observed shocks either to income, or demand for, or cost of, the public good. Notable results are: (i) depending on the source of the shock, the grant may induce over- or undersupply of the public good relative to the Samuelson rule; (ii) with public good spillovers between regions, there is two-way distortion of public good supply — that is, qualitatively different distortions (relative to the Samuelson rule) for different values of the shock; (iii) the solution to the central government's problem may depend qualitatively on whether regional taxation is lump-sum or distortionary.