The architecture of government fiscal systems presents one of public economics' most complex optimization problems. How should taxing and spending powers be distributed across federal, state, and local governments? The answer shapes everything from public service delivery to economic efficiency to the fundamental character of democratic governance.

Standard economic theory offers competing frameworks. The decentralization theorem suggests local provision maximizes welfare when preferences vary across jurisdictions. Yet mobility creates tax competition, spillovers generate inefficiencies, and redistribution faces fundamental constraints at subnational levels. Resolving these tensions requires moving beyond simple principles toward a systematic analysis of how different fiscal instruments interact with household and firm behavior across governmental tiers.

This analysis develops the theoretical foundations for optimal fiscal assignment, drawing on mechanism design principles and empirical evidence about intergovernmental fiscal dynamics. We examine how competitive pressures from mobility can both enhance and undermine welfare, how grant systems and harmonization address cross-boundary externalities, and why redistributive assignment presents unique challenges that typically favor centralization. The framework that emerges provides guidance for designing fiscal federalism structures that balance efficiency, equity, and political feasibility—the core objectives of any well-functioning public finance system.

Charles Tiebout's 1956 model transformed how economists think about local public goods. In his framework, mobile households vote with their feet, choosing jurisdictions that offer their preferred combinations of taxes and services. This mobility creates competitive discipline analogous to market competition, potentially achieving efficient provision without the preference revelation problems that plague centralized systems.

The efficiency gains are real under specific conditions. When households are perfectly mobile, jurisdictions are numerous, and there are no spillovers or scale economies, Tiebout sorting achieves first-best outcomes. Local governments become price-takers, forced to provide services at minimum cost or lose residents. This competitive pressure generates productive efficiency while sorting achieves allocative efficiency by matching households with their preferred public good bundles.

However, the mechanism contains fundamental limitations that optimal fiscal design must address. Capitalization effects create inefficiencies when fiscal differentials become embedded in property values. A jurisdiction with superior schools sees housing prices rise, potentially excluding low-income households regardless of their preferences. The sorting that enhances efficiency for mobile households simultaneously creates barriers for those with limited mobility.

Tax base mobility introduces additional distortions. When capital or high-income residents can easily relocate, local governments face constraints on taxation that may be inefficient from a national welfare perspective. The resulting tax competition can produce a race to the bottom, with jurisdictions cutting services and taxes below optimal levels to attract mobile factors. Empirical estimates suggest this competition reduces local tax rates by 10-30% below what immobile-factor models would predict.

The welfare implications depend critically on the type of public goods provided. For services with strong preference heterogeneity—education quality, environmental amenities, local infrastructure—Tiebout mechanisms offer genuine efficiency advantages. For services where heterogeneity is limited or where sorting creates negative externalities—emergency services, basic utilities, poverty assistance—the competitive model breaks down. Optimal assignment requires distinguishing these categories and designing appropriate institutions for each.

Takeaway

Mobility creates competitive discipline on local governments, but the welfare effects depend entirely on what's being competed over—sorting works for preference-driven services but fails for redistribution and services requiring scale.

Cross-jurisdictional externalities represent the central market failure in decentralized fiscal systems. When one jurisdiction's policies affect residents of neighboring jurisdictions—through pollution, infrastructure networks, or educated workers who migrate—local decision-makers systematically underprovide beneficial spillovers and overprovide harmful ones. The magnitude of these inefficiencies can be substantial.

Matching grants provide the primary mechanism for spillover internalization. A central government offers to match local spending at a rate equal to the spillover fraction—if 40% of education benefits accrue to other jurisdictions through eventual worker migration, a 40% matching rate aligns local incentives with national welfare. The theoretical elegance is compelling, but implementation requires accurate spillover measurement, which empirical research rarely achieves precisely.

Tax harmonization addresses spillovers from the revenue side. When jurisdictions compete through tax rates rather than service provision, harmonization prevents races to the bottom while preserving some local autonomy. The European Union's minimum VAT rates and corporate tax proposals exemplify this approach, though the optimal degree of harmonization depends on the mobility of affected tax bases and the heterogeneity of local preferences.

Empirical evidence on grant effectiveness reveals important design considerations. Flypaper effects—where grants increase local spending by more than equivalent income increases would—suggest grants work partly through political economy channels rather than pure price effects. Categorical grants with maintenance-of-effort requirements perform better than unrestricted transfers at increasing targeted spending, but impose administrative costs and reduce local flexibility.

The optimal response to spillovers isn't always internalization through grants. When spillovers are sufficiently large or difficult to measure, centralization of the function itself may dominate decentralized provision with corrective transfers. Transportation networks, environmental regulation, and communicable disease control often fall into this category—the transaction costs of designing and monitoring appropriate grant structures exceed the efficiency gains from preserving local choice.

Takeaway

Spillovers justify intergovernmental transfers, but the choice between matching grants, harmonization, and outright centralization depends on spillover magnitude, measurement feasibility, and the administrative costs of each corrective mechanism.

Redistribution presents unique assignment challenges that generally favor centralization. The economic logic is straightforward: mobile high-income households can escape local redistribution by relocating to low-tax jurisdictions, while mobile low-income households are attracted to generous benefit programs. This creates fiscal pressure that constrains local redistributive capacity far below what local preferences might support.

The race to the bottom in welfare benefits illustrates the dynamic. When jurisdictions compete for mobile residents, those offering generous benefits attract net fiscal burdens while those offering minimal benefits attract net fiscal contributors. Even jurisdictions whose residents prefer substantial redistribution may be forced to constrain programs to avoid becoming welfare magnets. Empirical studies of U.S. state welfare programs suggest this competition reduces benefit levels by 15-25% compared to a centralized counterfactual.

Central provision of redistribution eliminates these fiscal externalities. When redistribution is funded and administered nationally, mobile households cannot escape contributions by relocating domestically, and benefit levels reflect national rather than local political economy constraints. The efficiency gain is substantial: centralization allows redistribution to be determined by genuine preferences rather than by competitive fiscal pressures.

Exceptions to centralized redistribution exist but are narrower than often assumed. Local provision may be appropriate when preference heterogeneity for redistribution is high and mobility is low—conditions rarely satisfied simultaneously in practice. Place-based redistribution targeting geographically concentrated disadvantage can also justify local administration, though funding typically still requires central involvement to avoid the fiscal externality problem.

The assignment of redistribution has implications beyond direct transfer programs. Tax progressivity, public service quality differentials, and regulatory policy all have redistributive components. Comprehensive analysis suggests centralizing not just explicit transfers but also the progressivity structure of major tax instruments—a conclusion that explains why income taxes are typically federal while property taxes remain local in most federalism structures.

Takeaway

Mobile residents undermine local redistribution through both exit and entry, making central assignment of redistributive functions not merely convenient but necessary for achieving any substantial degree of income redistribution.

Optimal fiscal federalism requires matching governmental functions to the level where the relevant efficiency and equity considerations are best addressed. Tiebout mechanisms work when preference heterogeneity is high, mobility is moderate, and spillovers are limited—conditions met for many local services but not for redistribution or networked infrastructure.

The theoretical framework developed here suggests a more nuanced assignment than simple decentralization versus centralization debates allow. Spillover-adjusted matching grants, strategic tax harmonization, and centralized redistribution each address specific market failures while preserving beneficial aspects of decentralized provision.

Implementing these principles requires institutional capacity that many fiscal federalism structures lack. The gap between theoretical optima and actual assignment patterns reflects political economy constraints, path dependence, and measurement limitations. Understanding this gap—and designing institutions that narrow it—remains the central challenge for fiscal federalism design in practice.