Fiscal federalism, local public works and corruption

In ¯fiscal federal systems, local public works that generate spillovers are often ¯nanced by transfers from higher levels of government. In this article, we consider a governmental hierarchy composed by a Federal and a Local Government. The former delegates to the latter the task of ¯nding a ¯rm to undertake a local public work. As the Local Government has more information about the e±ciency of the firm, it communicates its private information to the Federal Government which decides the way to fund the project. If side-contracts between the local authority and the ¯rm in charge with constructing the project are feasible, di®erent stakes for collusion may arise. The Local Government can overstate the e±ciency of the ¯rm to obtain extra rents or can also understate it, to ensure the e®ective undertaking of the project. In order to ¯nd the optimal allocations, we derive a \Collusion-Proofness" property which states that, in order to maximize its expected welfare, the Federal Government can restrict to o®er collusion-proof contracts. These contracts indicate the transfers between the Federal Government, the local authority and the ¯rm of constructors. Finally we characterize the distortions set to attenuate the resulting implementation costs. They concern the cost of the project and the decision about its e®ective undertaking. The most important result of this article is that the undertaking of useless projects, at an in°ated cost, is an optimal response of the Federal Government to the threat of collusion between the local authorities and the firm of constructors.