Bribing the Grantee: Asymmetric Information and the Enforcement of Local Minimum-Provision Levels through Grants-in-Aid

A principal-agent approach is used to analyse the problem of a central government that wants to stimulate the provision of local public services, given that lower level governments are better informed about production costs. Specifically, the centre wants the provision level to be such that at least a minimum standard is provided. If the imposition of such a standard is constitutionally ruled out, what should an appropriate grant look like. It is explicitly recognised that the decision whether or not to accept the proposed grant scheme may vary for different types of recipients. In addition, the grant must be incentive compatible. This is achieved by including information-eliciting payments in the transfer, which in turn influences the optimal provision level: more types will be set at the minimum-provision level, relative to a perfect-information setting. The qualitative nature of the optimal grant scheme itself is profoundly influenced by just the addition of information asymmetry.