NONLINEAR INCOME TAXATION AND MATCHING GRANTS IN A FEDERATION WITH DECENTRALIZED IN-KIND TRANSFERS

We extend to a fiscal federalism setting the literature on redistributive in-kind transfers in the presence of nonlinear income taxation. Local governments have a cost advantage, motivating decentralization of the in-kind transfer. The cost structure varies across regions, and the central government cannot observe which region is which. We show that decentralized in-kind transfers can, in this setting, be an even more important instrument for relaxing self-selection constraints, thus, helping redistribution, than in single-government models. We characterize the optimal marginal tax rates and matching grants. The grants have a very different structure than the one derived in earlier studies. Copyright © (2009) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.