Devolution and grant-in-aid design for the provision of impure public goods

Traditional fiscal federalism theory postulates that devolution for the provision of local public goods increases welfare. However, most of the services nowadays offered at local level are impure local public goods with spillovers whose characteristics may prevent devolution being efficient. Our paper shows that devolution is the optimal choice only for local impure public goods. In the presence spillovers, devolution without any correction from upper tier is never optimal. For an environment characterised by coordination and asymmetry of information problems, we propose the optimal grants-in-aid formula that Central Government should use to reduce the welfare loss caused by devolution and we compare it with what suggested by the mainstream literature. Finally, we compare devolution with a centralised solution where the impure public good is supplied by the upper government level. From a policy point of view, our paper may explain the choices made by countries in terms of allocation of functions in the provision of merit and impure public goods.