Mean Field Games and Incentive Regulation of Intergovernmental Transfers: Extending Laffont–Tirole to Fiscal Federalism

This paper develops a new dynamic framework for designing intergovernmental fiscal transfers by combining incentive regulation, fiscal feder alism, and mean field games. Building on Laffont and Tirole's classic theory of cost observation and hidden effort, we model a central government that offers linear transfer contracts to a continuum of local governments whose costs evolve stochastically. Local cost dynamics follow Ornstein-Uhlenbeck, Cox-Ingersoll-Ross, or mean-reverting geometric Brownian motion processes and may experience rare jump shocks. Each locality chooses unobservable cost-reducing effort, while the center optimizes the transfer rule to induce truthful reporting and efficiency. Using Hamilton-Jacobi-Bellman and Fokker-Planck equations, we characterize stationary and transitional equilibria and show that yardstick competition provides the strongest incentives with minimal fiscal cost. The model yields explicit conditions for long-run fiscal sustainability and illustrates how robust transfers can sustain effciency and equity under uncertainty.