A model of regional equalisation transfers under asymmetric information with reference to the spanish regional financing system

This paper considers the design of equalisation transfers in the presence of asymmetric information with respect to the provision cost of regional public output (Adverse selection). To overcome this problem, the central layer of government has to design an optimal incentive-compatible direct co-ordination mechanism. This provokes a distortion in the (optimal) private decisions of the high-cost type governments in order to opt to the transfers. Moreover, both levels of government levy a tax on labour income in such a way that a vertical tax externality also crops out, and affects private decisions of high and low-cost type regions. The model which will infer such results is a preliminary attempt, open to future research, to approximate to the present Spanish situation, and achieve useful recommendations based on economic theory.