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Grants in Aid to Local Government: Median Voter and Political Biases

The traditional theory for fiscal federalism assumes that the lower tier is more efficient in producing local public goods because of information asymmetry, while on the finance side Central Government might be more efficient in raising resources that will then be distributed through grants-in-aid. This scheme does not take into account that services produced at local level are usually impure public goods and that Central Government might want to pursue other objectives instead of a straight maximisation of social welfare. The model developed in this paper allows to derive grants-in-aid distribution formulae in this environment. The modelling structure is based on Lancaster's characteristic approach as applied to impure public goods by Cornes and Sandler (1994). It is shown that when political considerations enter in the allocation process, the second theorem of fiscal federalism is no longer valid. The model is then able to give another compelling institutional reason for the flypaper effect.