The architecture of federations: Constitutions, bargaining, and moral hazard

The paper studies a federal system where (a) a region provides non-contractible inputs into the social benefits from a public policy project with spillovers to other regions, and (b) where political bargaining between different levels of government may ensure efficient decision making ex post Allowing intergovernmental grants to be designed optimally, we ask whether project authority should rest with the region or with the central-government. Centralization is shown to dominate when governments are benevolent. With regionally biased governments, both centralization and decentralization yield inefficiencies and the second-best institution depends on parameter values if political bargaining is prohibited. When bargaining is feasible, however, the first best can often be achieved under decentralization, but not under centralization. At the root of this dichotomy is the alignment of decision making over essential inputs and project size under decentralized governance, and their misalignment under centralization. (C) 2014 Elsevier B.V. All rights reserved.