An Optimal Grants-in-Aid Allocation Rule in the Context of an Asymmetry-of-Information Model

The antithesis between autonomy, equity, and efficiency are central elements in fiscal federalism. The literature argues that the existence of lower tiers depends on their ability at being better informed than the centre on local preferences and suggests that central government should exercise its control mainly through the grant allocated to each tier. However, setting up an efficient system requires the knowledge of nonobservable local parameters, and this creates an asymmetry-of-information problem that the literature on grants-in-aid has not recognized so far. This paper is an attempt to fill this gap. An optimal grant system that central government could use to reach an efficient allocation of resources within an intertemporal model characterized by asymmetry of information is described. The optimal grant formula is set in a dynamic framework by using an approach taken by Harris and Townsend in 1981. The formula obtained is very general and can be applied to many other situations involving delegated choices.