Taxation and Intergovernmental Grants in a Federal Government System

The paper applies some game-theoretic and incentive arguments to the analysis of fiscal federalism. First, decentralized taxation in a setting with agents having costly opportunities to move across states is modeled as a game between state governments. A central government is introduced as an agent assuring cooperation. For repeated taxation-games it is shown how outcomes vary with the characteristics of taxes. The second part of the paper is concerned with optimal design of intergovernmental grants when local governments have better information than the center. Generally, asymmetric information provides a justification for conditional grants.