Optimal Regional Redistribution Under Asymmetric Information

This paper studies optimal redistribution among two different regions in a federal state. Regional governments supply local public goods financed with distorting local taxes. They have better information on their tax bases than the federal government. We model this both as an adverse selection problem on the size of local tax bases and/or as moral hazard problem on local tax enforcement. Moral hazard alone does not affect the first best redistribution rule, which is a lump sum transfer from the rich to the poor region. In all other cases the optimal transfer rule involves a lump sum tax on the rich regions and a premium for fiscal effort by the poor regions, with the transfer falling short of the first-best level. In the equilibrium with moral hazard and adverse selection, tax evasion occurs only in the poor region, even though the possibility of lax tax enforcement benefits the rich and harms the poor region because it reduces equilibrium redistribution.