Optimal Regional Insurance Provision: Do Federal Transfers Complement Local Debt?

Authors: Liqun Liu, Darong Dai, Guoqiang Tian Date: November 2019

Working paper 1914

Intergovernmental grants implemented by the central government of a federal fiscal system are justified on the grounds that they internalize interregional spillovers generated by local public goods provision or inter-jurisdictional migrations, redistribute income between regions, and serve as a risk-sharing device against region-specific shocks.
In this working paper, the authors study the design and implementation of optimal regional insurance provision against privately observable shocks to the degree of intergenerational externality (DIE) induced by, or the degree of technological progress (DTP) for producing, intergenerational public goods (IPGs). Federal transfers provide interregional insurance while local debt provides intergenerational insurance. If regions have autonomy in the choice of local debt issuance, the optimal allocation of federal transfers that induces truth-telling requires that regions issuing higher debt receive more transfers under complementarity but less transfers under substitutability. In the case of shocks to the DIE, federal transfers and local debt are complementary in implementing the asymmetric-information optimum; in the case of shocks to the DTP, they are complementary with observable output of the IPGs, but are substitutive with observable expenditure on the IPGs.

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Keywords: Intergovernmental grants, interregional insurance, regional public debt, durable public goods, intergenerational externality, asymmetric information