Journal of Economic Studies

Fiscal externalities in a three-tier structure of government

Andreas Kappeler
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Andreas Kappeler , (2014),"Fiscal externalities in a three-tier structure of government", Journal of Economic
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Three-tier
Fiscal externalities in a three-tier structure of
structure of government government
Andreas Kappeler
Economics Department, OECD, Paris, France
863
Abstract
Purpose – Federal systems are often more sophisticated than assumed in the literature. In many
cases, at least three tiers of government are involved in federal decision making. The purpose of this
paper is to cast some light on this increasingly important issue in fiscal federalism.
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Design/methodology/approach – In a model with three tiers of government, the author analyzes

corrective policies in the presence of fiscal externalities generated by federal redistribution.
Findings – The author identifies an additional qualitative incentive effect, particularly for intermediate
governments. They behave strategically to attract additional redistribution funds from outside, though
still using corrective policies to provide investment incentives toward their own regions. The results also
suggest that differently from the USA the federal system of the EU may lead to inefficiently low regional
investment.
Originality/value – The presented model is a first step toward analyzing strategic behavior and the
effect of corrective policies in more complicated federal set ups with three tiers of government involved.
This is relevant for federal structures such as Germany or the USA, as well as for government
interactions at the international level.
Keywords USA, EU, Conditional grants, Federal redistribution, Public investment, Fiscal federalism
Paper type Research paper

1. Introduction
In contrast to the common assumption in the literature on fiscal federalism, more than
two tiers of government are involved in most federal decision making. E.g. regions in
the US finance expenditure by about 20 percent through federal transfers and by 35
percent through state grants. On the other hand, local governments in the European
Union (EU) receive more than 70 percent of grants from national governments, while
the EU itself only plays a minor role in the provision of regional funds[1]. The EU
usually transfers these grants to national governments, which then can decide on how
to allocate EU-funds among its regions. In this sense, the role of intermediate
governments is much stronger in Europe than in the USA.
This paper investigates corrective policies in a three-tiered federal redistribution
system. Federal redistribution generates externalities leading to strategic behavior
and under-investment by all regions (e.g. Dahlby, 1996). The middle- and high-level
governments can provide conditional transfers toward the regional level in order to
restore optimal regional investment. By referring to the federal structures of the EU
and the USA, the analysis shows that the allocation of power between the two highest

JEL Classifications — E62, H77, F02

The author is grateful to Maarten Allers, Thiess Buettner, Jin Cao, Andreas Haufler, Rainer
Lanz, Marco Runkel, Chen Zhao, and seminar participants at Munich University (LMU), the
Journal of Economic Studies
European Investment Bank and the IIPF conference, Warwick (2007), for many inspiring Vol. 41 No. 6, 2014
discussions and hints. Financial support from the German Research Foundation (DFG) is pp. 863-880
r Emerald Group Publishing Limited
gratefully acknowledged. Opinions expressed in this paper are those of the author. They do not 0144-3585
necessarily reflect the views of the OECD. DOI 10.1108/JES-03-2013-0033
 JES tiers of government crucially determines the behavior at each level of government.
41,6 In this context, the role of the middle-level governments is of particular interest.
The findings suggest that a qualitative shift of redistribution power toward the highest
level of government generates an additional, qualitative incentive effect for middle-
level governments. They want their own regions to under-invest in order to attract
additional redistribution funds from outside regions, but at the same time take
864 into account externalities among their own regions. Corrective matching grants by the
high-level and middle-level government are considered as well. In a federal structure
such as in the USA, high-level and middle-level governments can finance corrective
matching grants by levying taxes. In this setup, the middle-level government (states)
has a lower preference for regional investment than the high (federal) level. As a result,
only the highest level of government provides corrective matching grants.
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Differently from the USA, the EU can levy taxes only to a very limited extent.
The EU does receive contributions of countries based on their VAT revenue and GNI.
Most of these revenues are allocated to poor regions through EU structural and
cohesion funds. In other words, the EU can only redistribute funds from rich to poor
regions by providing conditional transfers for investment. In our setup this restriction
leads to inefficiently low investment, by rich and, under certain conditions, also by
poor regions.
This paper contributes to the literature on local public finance and fiscal federalism
(e.g. Oates, 1972; Tiebout, 1956) by analyzing conditional grants and decentralization.
Federal redistribution generates incentives for regions to under-invest. Thereby they
can attract higher federal support (Dahlby, 1996; Matheson, 2005; Fenge and Wrede,
2004). However, this literature does not account for incentives arising in more
sophisticated federal structures with more than two tiers of government. The literature
being closest to such an analysis considers two tiers of government combined with
an additional individual perspective by considering regional voters or firms (e.g.
Cremer and Pestieau, 1996; Cremer and Pestieau, 1997; Persson and Tabellini, 1996;
Qian and Roland, 1998). In most cases, this literature focusses on interactions
among the two tiers of government under incomplete information about the behavior
and incentive structure of individual voters or firms. Persson and Tabellini (1996)
investigate individual redistribution by two tiers of government and its impact on
investment. Instead, we consider an exogenous qualitative shift of redistribution
competences toward the higher tier of government. This allows focussing on
the evolution of externalities in a more complex federal structure with three tiers of
government as well as the interaction between corrective policies adopted by the two
higher tiers of government.
The paper proceeds as follows. Section 2 presents the basic model with two tiers of
government. Section 3 extends this setting to a three-tiered federal system with the
two highest levels of governments providing redistribution funds to poor regions.
Section 3.1 determines matching grant policies adopted by the two higher levels of
governments. Section 3.2 investigates the case where only the middle-level government
can levy taxes. Section 4 concludes.

2. Benchmark case: two tiers of government

This section presents a baseline model analyzing regional investment incentives and
corrective policies in a federal redistribution system with two tiers of government
and fiscal externalities generated by federal redistribution. The federal system consists
of one central government and a large number (N) of regions of type 1 and of type 2,
 respectively[2]. Production in region i is logarithmic and depends on its productivity Three-tier
parameter ri as well as public investment Ii: structure of
Y i ¼ ri  ln I i ð1Þ government
The analysis is undertaken from the perspective of a particular region of type 1.
We assume that r1or2, implying that region 1 is less productive than region 2. I1
represents productive investment by region 1, for instance in infrastructure. The
865
assumption that only regional governments invest in the model reflects that the bulk of
public investment across EU countries is undertaken at the regional level, more than 60
percent in EU-15 countries, according to Kappeler et al. (2013).
The representative individual in region 1 exclusively receives utility from private
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consumption C1. Individuals only benefit from regional public investment through
increases in per capita income. In order to isolate the pure strategic argument in this
framework, local public investment is assumed to generate no direct utility or spillover
effects. The private budget constraint reads:
P 2 
kY k
C1 ¼ Y 1 þ b   Y1  I1
2

According to this budget constraint, income deviations from the mean across all
regions are equalized by a share bA[0, 1] through federal redistribution. b ¼ 0 implies
that there is no federal redistribution; for b ¼ 1 regional income gaps are completely
offset. As we are mainly interested in how the provision of matching transfers provided
by higher levels of government depends on qualitative rather than quantitative changes
in the redistribution system, henceforth parameter b is considered to be exogenous.
Indeed, federal structures are usually established by complex political processes.
Therefore the level of federal redistribution can be assumed to be constant – at least in the
short- to mid-run.
Regional governments maximize linear utility of the representative consumer
subject to the private budget constraint. Thus, the regional objective function writes:
P 2 
kY k
U1 ¼ Y1 þ b   Y1  I1
2

Given that the number of regions, N, is large, the first order condition of a regional
government of type 1 writes qU1/qI1 ¼ (r1/I1 þ b  (r1/I1  )1) ¼ 0. This implies that
region 1 invest I1 ¼ r1  (1–b).
The utilitarian welfare function of the central government is the sum over the utility
of both types of regions:
X  P 2  
2 k Yk
W¼ i Y 1 þ b   Y 1  I 1 ð2Þ
2

Maximizing the objective functions of the central and regional governments wrt. I1
shows that income equalization at rate b leads to under-investment of both rich and
poor regions. In equilibrium, investment of poor regions (I1 ¼ r1  (1b)) is below the
social optimum (I1 ¼ r1), which can be derived by maximizing Equation (2) wrt. I1.
In line with Dahlby (1996); each region is aware of the positive income effect of its own
 JES investment as well as the negative impact of I1 on redistribution transfers received
41,6 from other regions: for a poor region, higher investment results in less transfers
received from rich regions. For a rich region, additional investment leads to higher
transfers to be paid to poor regions. In contrast, the central planer accounts for all fiscal
externalities. Therefore, the investment it would unilaterally pick exceeds the actual
investment of both rich and poor regions. Regional under-investment cannot be
866 resolved unless the center disposes over an additional policy instrument to set the right
incentives.
Since redistribution generates incentives for regions to under-invest, as shown
above, the center has to achieve two objectives at the same time. First, it has to assure
an exogenously given degree of redistribution among regions. Second, it has to
implement first best investment by introducing corrective policies. The standard
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literature in public finance proposes corrective matching grants to provide incentives

for regions to invest (e.g. see Oates, 1972). A matching grant is a conditional transfer
from the central to the regional government to provide spending incentives for lower
levels of government. Here, the central government finances a predetermined share gi
of regional investment thereby reducing the marginal cost of investment for the region.
Matching grants are financed through a general – non-distortive – lump sum tax, T. Note
that regions do not consider their contribution to finance investment transfers, as their
number, N, is large.
The budget constraint of the central government is defined as:
P 2 
k gk I k
T¼
2

With a conditional matching transfer gi toward regions i, the objective function of the
central government rewrites:
X  P 2  
2 k Yk
W¼ i Y 1 þ b   Y 1  ð 1  g 1 Þ  I 1  T ð3Þ
2

This imposes the following sequence on the model:

(1) the redistribution parameter, b, is exogenously determined;
(2) the central government determines the matching rate g1, financed by lump sum
tax T; and
(3) regional government 1 invests I1(g1, b, T).
Thus, the regional government moves only after it has been informed about matching
grants available from higher levels of governments. In fact, regional governments
usually are well informed about financial support available from higher levels of
government when taking their investment decisions.
Maximizing Equation (3) wrt. g1 yields:

P1. With exogenously given regional income equalization at rate b, matching rate
g1 ¼ b provided by the central government implements first best investment by
region 1.

Deriving the objective function of region 1 wrt. I1 yields its first order condition. This
can be simplified to Ii ¼ r1 ð1  bÞ=1  g1 . Thus, regional, investment decreases
 with the degree of redistribution and increases in matching transfers provided Three-tier
by the central government. Maximizing Equation (3) wrt. g1 yields, after some structure of
transformations, the marginal productivity of region 1 preferred by the central
government, qYi ðIi Þ=qIi ¼ 1. These two results determine the optimal matching rate, government
g1 ¼ b, which implements first best regional investment.
Without further intervention by the central planer, regional governments under-
invest for a given level of redistribution, b. In order to correct for strategic behavior, the 867
central government provides additional matching grants for regional investment.
If the center finances a share g1 of investment, regions effectively face a lower cost
of investment and are therefore willing to invest more. By setting g1 ¼ b, the center
implements first best regional investment, eliminating regional disincentive effects
arising from federal redistribution.
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A note of caution is in order here. Typically higher levels of government have some
degree of discretion in determining the level of redistribution. In this paper, however,
we are mainly interested in the federal structure itself and how regional investment
incentives are affected by the level and allocation of redistributive competences
at different levels of government. In order to keep our model tractable, the level of
redistribution is exogenously fixed.
Note that thereby a range of relevant issues are not considered, including the
question why redistribution exists in a federal system. Equity or risk sharing
considerations are not modeled in greater detail as this would considerably increase the
complexity of the model. Also, to keep the model tractable, political economy
arguments are not included that would allow modeling regional performance
based on the fiscal and political incentives that regional officials face (see, e.g.
Weingast, 2009).

3. Analysis with three tiers of government

This section presents a model with three tiers of government to discuss regional
investment incentives and corrective policies in the presence of fiscal externalities
generated by redistribution of the two higher tiers of government. In fact, disincentive
structures and optimal corrective policies are more complex in a federal system with
three tiers of government. E.g. consider the USA or the EU: Two tiers of government
(federal and state vs supranational and national governments) with distinct objectives
redistribute and engage in corrective policies toward their regions. Having said this,
there are crucial differences between the US- and EU-system. In the USA, both federal
and state governments can levy taxes to finance matching transfers. In the EU, only
national governments can levy taxes to finance conditional grants. Our model will
show that this difference in tax autonomy may have far-reaching implications for the
implemented level of regional investment.
In this model, the central government may either represent a federal or a
supranational government. This is labeled the high-level or H-government. The state
or national governments are called middle-level or M-governments. There are two
identical middle-level governments, labeled A and B, both consisting of a large number,
N, of identical poor regions of type 1 and 3 and of identical rich regions of type 2
and 4, respectively. Thus, r1 ¼ r3or2 ¼ r4. This assures symmetry in the model and
facilitates isolating the strategic behavior of governments at different levels. The high
level considers all four representative regions, each of the two identical middle-level
government only considers its own two types of regions. Each region only accounts for
the utility of its representative voter. This structure is shown in Figure 1.
 JES High-Level
41,6 Government
Redistribution share c

Middle-Level Middle-Level
868 Government A Government B
Redistribution share (b-c) Redistribution share (b-c)
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Figure 1.
N Regions of N Regions of N Regions of N Regions of
Type 1 Type 2 Type 3 Type 4

From the perspective of a regional government, redistribution transfers are determined

by two hierarchical levels, H and M. As before, redistribution is assumed to be
exogenously given but is now implemented by one middle-level and the high-level
government: A share (bc) of redistribution is realized by the middle-level government,
while a share c of redistribution is implemented by the high-level government. This
assures that parameter c captures a qualitative shift in redistribution power while
leaving its overall level unchanged. For instance, if 10 percent of the regional income
gap is to be covered by high-level redistribution, the middle-level government reduces
its share of redistribution by the same percentage. Note that for c ¼ 0, we fall back to
the benchmark case discussed in Section 2.
As discussed in some more detail at the end of Section 2, this paper focusses on
the federal structure itself. In order to keep our model tractable, we only focus on
investment incentives arising from exogenous changes in the level of redistribution (b)
as well as exogenous shifts in the allocation of redistributive competences across levels
of government (c). Political economy arguments (Weingast, 2009) or equity and risk
sharing considerations are not modeled explicitly.
As in Section 2, preferences are linear in consumption. Thus, marginal utilities are
constant and identical across regions[3]. Adopting again the perspective of a particular
region of type 1, the regional objective function writes:
P 2  P 4 
k¼1 Yk k¼1 Yk
U ðC1 Þ ¼ Y1 þ ðb  cÞ   Y1 þ c   Y 1  I1 ð4Þ
2 4
with b, c e [0, 1] assumed to be exogenously given and bXc. We define Y i(  ) ¼
Yi(Ii ) ¼ Yi. The middle-level equalizes income differentials by a share bc between its
own two types of regions. The high-level government equalizes income disparities by a
share c over all four types of regions.
Middle-level government A considers utilitarian welfare of representative regions of
type 1 and 2:

X  P 2  P 4  
k¼1 Yk k¼1 Yk
WAM ¼ 2
i¼1 Yi þ ð b  c Þ   Yi þ c   Yi  I i ð5Þ
2 4
 Correspondingly, the high-level government maximizes utility over all four types Three-tier
of regions: structure of
X  P 2  P 4  
k¼1 Yk k¼1 Yk government
WH ¼ 4
i¼1 Y i þ ð b  c Þ   Y i þ c   Y i  I i ð6Þ
2 4

To start with, let us identify the effect of a shift in redistribution power toward the
highest level (as measured by parameter c) on investment incentives of regional,
869
middle-level, and high-level governments. Note that regions can realize their own
preferred level of investment, as long as M- and H-governments do not have matching
transfers as additional policy instrument. The investment that the middle-level
government would pick unilaterally for region i is labeled IM i , the one the one of the
high level is labeled IH
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i . These investment levels are determined by maximizing

Equations (5) and (6) with respect to Ii, respectively. This leads to:

Lemma 1. Assume that redistribution is implemented jointly by a M- and a

H-government. Then:
(i) the investment level picked unilaterally by a region of type 1, I1, decreases in b;
(ii) the regional investment level that is preferred by the M-government, IM
1 ,
decreases in c;
(iii) the regional investment level that is preferred by H-government, IH 1 , is
independent of b and c and corresponds to the first best solution; and
(iv) IH M
1 4I1 4I1.

Proof see Appendix.

Along the line of argument in Section 3, fiscal externalities at the regional level
increase in the redistribution parameter b: for a higher value of b, regions have fewer
incentives to invest as income differences are balanced to a higher degree. In contrast,
regional investment is not affected by a shift in redistribution power among high-level
and middle-level governments as measured by parameter c. This result holds, as the
number of regions of each type is large: A transfer of more redistribution autonomy to
a higher level – considering more regions – does not change the strategic considerations
of a regional government that already competes with a large number of regions[4].
As to the middle-level governments, they consider regions within their own borders
only. Due to constant marginal utilities and the symmetry in our model, redistribution
among their own regions does not generate disincentives. The M-government does take
into account the fiscal externalities arising among its own regions. In contrast, for any
c40, a lower output in region 1 leads to more redistribution at the central level and thereby
resource inflows from outside regions. Thus, the middle-level government only accounts
for the qualitative changes in redistribution power by behaving more strategically for c
increasing. As M accounts for strategic behavior among its own regions, its preferred level
of regional investment will always exceed the one chosen by a regional government.
The high-level government maximizes utility over all regions in the federation.
It properly accounts for all existing fiscal externalities within the system. Therefore, its
investment objective is independent of b. For the same reason a qualitative change
of redistribution – measured by a change in parameter c – does not affect the regional
investment level that would be unilaterally picked by the high level. In the equilibrium,
 JES its preferred regional investment level is above the preferred level of both middle level
41,6 and regional governments and identical to the result for the central planer in Section 2.
Thus, IH1 corresponds to the first best.
Without corrective policies, H- and M-governments have no means to affect regional
behavior and thus regions under-invest. Therefore, we introduce – as corrective
policies – matching grants provided by high- and the middle-level government
870 toward their regions. Two settings are of particular interest: Section 3.1 assumes that
conditional transfers are financed by lump sum taxes by both M- and H-governments.
This setting resembles the federal structure in the USA. Section 3.2 refers to a structure
similar to the EU, where the highest level of government cannot impose taxes, but
provides redistribution funds conditional on investment.
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3.1 Matching grants

In the following, conditional transfers are introduced, which are financed through
lump sum taxes by both the high level and middle level. The high-level government
may be interpreted as a federal government, intermediate governments correspond to
state authorities. Consider b and c again to be exogenously determined and a federal
structure as described in Figure 1. Both middle- as well as high-level governments
levy lump sum taxes to finance investment grants. The sequence of the model evolves
as follows:
(1) redistribution parameters b and c are exogenously determined;
(2) simultaneous move game between M- and H-government in gH M
1 and g1 ; and

(3) regional governments invest I1(gM H

1 , g1 , b, c, T).

gM H
1 and g1 are region-specific matching rates of the middle-level and high-level
government, respectively. We impose two non-negativity constraints: gM 1 X0 and
gH
1 X0. Referring again to a particular region of type 1, its objective function rewrites:

 P 2  P 4  
k¼1 Yk k¼1 Yk
 
U1 ¼ Y1 þ ðb  cÞ   Y1 þ c   Y1  1  gM 1  g H
1 I 1  T
2 4
P2 M P4 H
With T ¼ TM þ TH defined by 2  T M ¼ H
k gk Ik and 4  T ¼ k gk Ik . In this
M H
setting g1 and g1 are strategic substitutes and financed by lump sum taxes. As the
number of regions, N, is large, they consider their own contribution in the financing
of matching grants to converge to zero. The maximization problems of H- and
M-governments are set up correspondingly based on Equations (5) and (6). Solving this
game backwards leads to:

P2. Assume that redistribution is implemented jointly by a M- and a H-government

and matching transfers are financed by lump sum taxes. Then, in the unique
Nash Equilibrium, gH M H
1 40 and g1 ¼ 0. The first best regional investment, I , is
implemented.

Proof, see Appendix.

Conditional grants are provided only by the high-level government, which prefers
higher regional investment than the middle level. The H-government completely
takes into account fiscal externalities and therefore aims at implementing first best
investment. On the other hand, the M-government targets an investment rate by
 regions below the welfare maximizing level, as it does not account for all externalities Three-tier
for c40 (see Lemma 1). In equilibrium, the high-level government can implement first structure of
best regional investment by choosing its matching rate gH40 high enough. Thereby,
the high-level government provides investment incentives to regions that go beyond government
the level preferred by the M-government. As gH and gM are substitutes and as gM is
bounded from below (g1A[0,1]), the middle-level government does not provide any
investment grants. The only equilibrium is a corner solution with only the H- 871
government providing matching transfers.
This result can be related to the federal system of the USA. According to our results,
state governments want their own regions to strategically under-invest in order to
attract additional funds from outside regions. Indeed the US-federal government runs
600 grant programs directed to regional and state governments, 550 of them being
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categorical (see Ford, 1999; for further details). In light of our results the comparatively
strong role of the federal government in the USA indicates that it is aware of
the strategic behavior of regional as well as state governments arising from the federal
structure.
While our model is able to explain the comparatively strong role of the federal
government in the USA, it is not able to justify the fact that also state (middle level)
governments provide investment grants and have a certain degree of tax autonomy in
the USA. This reflects the simplifying nature of the model, which is unable to capture
all aspects of federal decision making. The subsidiarity principle may justify the
provision of matching transfers by middle-level governments for reasons going beyond
the analytical framework chosen in this paper. This also includes possible information
asymmetries between different levels of government, which might justify the provision
of monetary incentives to regions by state governments as well. Also political economy
arguments may matter in this context, but are not considered by our analytical
framework (see, e.g. Weingast, 2009).
3.2 High-level government without tax autonomy
Let us now turn to a federal system where the highest level of government is restricted
in its fiscal autonomy. Consider again a federal structure as in Figure 1. Again, a fixed
share c of redistribution autonomy is shifted toward the highest level. The number of
regions is large and regions 1 and 3 are identical and poor compared to regions 2 and 4,
which are identical as well.
However, inspired by the EU federal system, it is now assumed that the high-level
(supra-national) government is less influential compared to Section 3.1. In particular, it
is assumed that only middle-level governments can impose taxes. For the regional
budget constraint this implies T ¼ TM. In line with what can be observed for the EU,
this assumption implies that the highest level of government (EU institutions) disposes
over a limited amount of funds to be allocated to regions. As the H-government cannot
impose taxes to finance matching grants it can only use funds available through its
redistributive mandate – which is determined by the size of parameter c in our model –
to provide matching grants. In other words, in the absence tax autonomy, the
H-government provides redistribution funds either in conditional or unconditional
form depending on whether it wants to provide incentives for regions to invest. This
implies the following budget constraint for the high-level government:
P 4 
k¼1 Y k
0pti þ g  I i pc 
H
 Y1 ð7Þ
4
 JES t1 represents a lump sum transfer with t1X0. As before, gHA[0,1]. Equation (7) can be
41,6 interpreted as a constraint to finance matching grants through redistribution funds
directed toward this particular region. The total amount of matching grants payable
to aP region cannot exceed its eligibility for redistribution funds from H,
4
c k¼1 Y k =4  Y 1 . If redistribution funds at the high level are available beyond
its need to finance matching grants, it can in addition pay a lump sum transfers t1.
872 Along the lines of Equation (4), the objective function of a poor region now writes:
 P 2  
k¼1 Yk
 
C 1 ¼ Y1 þ ð b  c Þ   Y1  1  g M 1  g H
1  I 1  T M
þ t 1
2

Poor regions receive matching grants from H- and M-governments. The high-level
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finances its matching grants exclusively through redistribution funds, while the
middle-level government can impose taxes to finance its investment grants.
As the high-level government does not provide redistribution funds to rich regions,
it has no means to provide any investment incentives toward regions of type 2
(Equation (7) is bounded from below and t2 ¼ gH I2 ¼ 0). Therefore, the objective
function of a rich region writes:
 P 2  P 4  
k¼1 Y k kY k
 M
 M
C 2 ¼ Y 2 þ ð b  cÞ   Y2 þ c   Y 2  1  g2  I 2  T 2
2 4

Rich regions do not receive matching transfers from the H-government but contribute
to finance redistribution funds toward poor regions. Solving this game backwards
leads to:

P3. Assume that the H-government can finance its matching transfers through
redistribution funds, only. Then. First, rich regions receive matching grants
only from the M-government and invest below first best (IM 2 ).

Second, for a poor region three cases can be distinguished. For, c4 c, the high-level
government can implement its first best regional investment (IH 1 , see Lemma 1) in
line with P2. For coc. The middle-level government can implements its desired
sub-optimal level of regional investment (IM 1 ) and both H- and M-government provide
matching grants. In the intermediary range, coco c, the realized regional investment
is below first best but higher than desired by the M-government, meaning that only the
H-government provides matching grants.
Proof, see Appendix.
For rich regions, the intuition is straightforward. The high-level government does
not have authority to tax. Since rich regions contribute to the redistribution system, the
high level does not have means to provide any funds toward rich regions. On the other
hand, the middle-level government finances matching transfers through lump sum
taxes as before. It is therefore able to provide matching grants also toward rich regions.
Because middle-level governments want all their regions to strategically under-invest
(desire to attract redistribution funds from outside regions), they provide too little
matching grants. Accordingly investment in rich regions is below the first best.
For poor regions, three cases can be distinguished as shown in Figure 2:
. In rage 3 ( c4
c ) the constraint in Equation (7) is not binding. The H-government
uses redistribution funds paid by rich regions in order to implement first best
 I1
1 2 3 Three-tier
cH > 0 cH > 0 cH > 0 structure of
cM > 0 cM = 0 cM = 0 government

I1H
873
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I1M

Figure 2.
c
c c–

investment, IH
1 , in poor regions. This is achieved by providing redistribution
funds toward poor regions conditional on investment. Redistribution funds
which are not needed to provide investment incentives can then be paid in lump
sum form, that is t140. This scenario is comparable to the corner solution in P2
with gH40 and gM ¼ 0.
. In range 2 ( coco c ) the value of c is too low so to assure that the H-government
can implement its preferred level of regional investment. The constraint in
Equation (7) is binding. However, c is large enough, it allows the H-government
to provide investment grants to an extent that it can implement a level of
regional investment, which is above the one preferred by the middle level.
Although first best investment cannot be implemented, regions invest is above
what the M-government desired, that is I M H
1 pI 1 pI 1 . In this case, M does not
provide any matching grants.
. Finally, in range 1 ( coc ) redistribution funds provided by the high level are not
high enough to provide sufficient incentives for poor regions to implement
the unilaterally preferred choice of the M-government (IM 1 ) – even if the
H-government provides all its transfers conditional on regional investment.
Since the H-government wants to get as close as possible to its own unilaterally
preferred level of regional investment, it provides all its available funds
conditional on investment. Therefore, gH 1 40 and t1 ¼ 0. The middle level then
provides additional matching grants until IM M
1 is implemented, thus g1 40.

The results in this section can be related to the federal system of the EU. The EU
provides most of its redistribution funds conditional on investment toward poor
regions under its objectives 1 and 2 (EU Structural and Cohesion Funds). These funds
are financed by countries based on their VAT revenue and GNI. The fact that rich
countries contribute more to finance EU-funds than poor regions reflects the
redistributive aspect of our model.
According to the results above, the fact that EU Structural and Cohesion Funds are
earmarked suggests that the EU does not have enough redistribution funds available
to provide sufficient investment incentives toward poor regions. In this case, the
 JES current EU-system would correspond to range 1 or 2 in Figure 2 implying that both
41,6 poor and rich regions under-invest.
Note that the EU mostly transfers funds to national governments, which then
distribute them among their regions. This is not reflected in our model and could
introduce a source for strategic behavior by middle-level governments.

874 4. Conclusions
Unlike in most of the theoretical literature, federal systems are often organized over more
than two tiers of government. This paper has proposed a framework to analyze corrective
policies in a three-tiered federal system. Our model reveals that a qualitative shift in
redistribution power toward the highest level of government reduces the regional investment
level desired by the middle-level government. This may be interpreted as an additional,
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qualitative effect of redistribution arising in a federal system with three tiers of government.
In this context, the paper investigates corrective policies by the two higher levels of
government directed toward their regions. First, we assume that both tiers of government
can finance their preferred level of corrective matching grants through lump sum taxes.
The middle-level government wants its own regions to strategically under-invest in order
to attract redistribution funds from outside regions. Since the highest level of government
accounts for all existing disincentives in the system, it aims at implementing first best
investment. In the unique Nash Equilibrium, only the highest level of government
provides conditional transfers. Second, corresponding to the federal structure of the EU,
we assume that only middle-level governments can finance matching grants through
lump sum taxes. In this case, the high-level government can provide investment incentives
only if it imposes investment restrictions on funds it has available for redistributive
purposes. Therefore, investment of poor regions crucially depends on the redistribution
autonomy delegated toward the highest level of government. Only if the upper level has
sufficient redistribution funds available, it can provide enough conditional transfers to
assure first best investment in poor regions. In contrast, the high-level government has no
means to provide any funds conditional on investment toward rich regions (they
contribute to federal redistribution). As a result, investment in rich regions is too low.
The implications of the model can be related to the federal systems of the EU and
the USA. Results from Section 3.1 seem to reflect incentives arising in a federal system
similar to the one of the USA. In this case it is mainly the federal government that
provides investment incentives in order to implement optimal regional investment.
On the other hand, the findings in Section 3.2 can be related to the federal system
in Europe, where the tax autonomy of the highest level of government is limited.
According to the model, the fact that the EU provides all its funds conditional on
investment suggests under-investment in both rich and poor regions and that more tax
autonomy is needed at the EU level.
The proposed setting is but a first step in analyzing more complex federal systems
and the interpretation of our results in context of the EU and US federal system should
be taken with a pinch of salt. There is plenty of scope for future research in this
increasingly important field. E.g. in the current model, redistribution is considered to
be exogenous despite the assumption of a welfare maximizing government in order
to keep the model tractable. Equity or risk diversification considerations could be
modeled explicitly so to endogenize redistribution. Also the model could be extended to
consider possible information asymmetries among different levels of government as
well as political economy arguments to account for fiscal and political incentives that
regional officials face (see, e.g. Weingast, 2009). Finally, an empirical verification of our
 findings could be interesting. Indeed, some recent empirical evidence suggests that Three-tier
centralization may negatively affect productive regional investment (e.g. Gonzalez structure of
alegre, 2010; Kappeler et al., 2013). However, such papers do usually not explicitly
account for redistribution or the federal structure. government
Notes
1. Portugal is one important exception. Its regions receive about 19 percent of grants from
international organizations. See Ford (1999) and Bergvall et al. (2006) for further details. 875
2. Usually, transfers are determined on the basis of GDP in precedent years and investment
today generates benefits in the future. However, introducing dynamics into the model
complicates the analysis without providing further insights.
3. With a non-linear utility function, results remain qualitatively unchanged, but computations
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complicate considerably.
4. Note that for small values of N this is not true. High-level redistribution then implies
redistribution over a larger number of (countable) regions resulting in an increase of strategic
behavior and thereby additional investment disincentives for each region.

References
Bergvall, D., Charbit, C., Kraan, D.-J. and Merk, O. (2006), “Intergovernmental transfers and
decentralised public spending”, Public Governance and Territorial Development
Directorate O.E.C.D., COM/CTPA/ECO/GOV/WP(2006)/3.
Cremer, H. and Pestieau, P. (1996), “Distributive implications of European integration”, Eur. Econ.
Rev., Vol. 40, pp. 747-757.
Cremer, H. and Pestieau, P. (1997), “Income redistribution in an economic union: the trade off between
inter- and intra-national redistribution”, Int. Tax. Public. Finan., Vol. 4 No. 3, pp. 325-335.
Dahlby, B. (1996), “Fiscal externalities and the design of intergovernmental grants”, Int. Tax.
Public. Finan., Vol. 3 No. 3, pp. 397-412.
Fenge, R. and Wrede, M. (2004), EU Regional Policy: Vertical Fiscal Externalities and Matching
Grants, mimeo, IFO Institute Munich, Munich.
Ford, A. (1999), Local Government Grant Distribution – An International Comparative Study,
PricewaterhouseCoopers, London.
Gonzalez Alegre, J. (2010), “Decentralization and the composition of public expenditure in Spain”,
Regional Studies, Vol. 44 No. 8, pp. 1067-1083.
Kappeler, A., Sole-olle, A., Stephan, A. and Valila, T. (2013), “Does fiscal decentralisation foster
regional investment in productive infrastructure”, European Journal of Political Economy,
Vol. 31 No. C, pp. 15-25.
Oates, W.E. (1972), Fiscal Federalism, Harcourt Brace Jovanovich, New York, NY.
Persson, T. and Tabellini, G. (1996), “Federal fiscal constitutions: risk sharing and moral hazard”,
Econometrica, Vols 64 No. 3, pp. 623-646.
Qian, Y. and Roland, G. (1998), “Federalism and the soft budget constraint”, Am. Econ. Rev.,
Vol. 88 No. 5, pp. 1143-1162.
Tiebout, C.M. (1956), “A pure theory of local expenditures”, Journal of Political Economy , Vol. 64
No. 5, pp. 416-424.
Weingast, B.R. (2009), “Second generation fiscal federalism: the implications of fiscal incentives”,
Journal of Urban Economics, Vol. 65 No. 3, pp. 279-293.
Further reading
Matheson, M. (2005), “Does fiscal redistribution discourage local public investment? Evidence
from Transitional Russia”, Econ. Transit., Vol. 13 No. 1, pp. 139-162.
 JES Appendix
Proof of Lemma 1
41,6 (i) Considering that the number of regions, N, is large, deriving the objective function of the
regional government wrt. I1 yields the FOC of the regional government:
 
qU ðC 1 Þ qY 1 ðI 1 Þ
¼  ð1  ðb  cÞ  cÞ  1 ¼ 0
876 qI 1 qI 1

Transforming this equation yields:

I 1 ¼ r1  ðb  cÞ
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Deriving wrt. b yields the result.

(ii) Deriving Equation (5) wrt. I1 yields the FOC of the M-government:
      
qW M qY1 ðI1 Þ 1 1
¼  1 þ ðb  cÞ  1 þc 1 1
qI1 qI1 2 4
     
qY1 ðI1 Þ 1 1 qY1 ðI1 Þ
þ  ðb  cÞ  þc  ¼0
qI1 2 4 qI1

This simplifies to:

c
IiM ¼ r1  ð1  Þ
2

Deriving wrt. c yields the result.

(iii) Deriving Equation (6) wrt. I1 yields the FOC of the H-government:

      
qW H qY1 ðI1 Þ 1 1
¼  1 þ ðb  cÞ  1 þc 1 1
qI1 qI1 2 4
         
qY1 ðI1 Þ 1 1 qY1 ðI1 Þ 1 qY1 ðI1 Þ
þ  ðb  cÞ  þc  þ c 
qI1 2 4 qI1 4 qI1
   
1 qY1 ðI1 Þ
c  ¼0
4 qI1

This simplifies to:

IiH ¼ r1

Deriving wrt. b and c yields the result.

(iv) Comparing the unilaterally preferred investment levels of the M- and the regional
government yields:

c
1  4ð1  bÞ
2
 for b, cA(0,1] and bXc. Comparing the unilaterally preferred investment levels the H- and the Three-tier
M-government yields:
structure of
c
141 
2
government

for cA(0,1]. It follows directly that I*1oIM H

1 oI1 .

Proof of Proposition 2 877

The proof consists of four steps:
1. The maximization problem of a region of type 1 yields FOC:
 
qU ðC 1 Þ qY 1 ðI 1 Þ
¼  ð1  bÞ  ð1gM
1 gH
1 Þ ¼0
qI 1 qI 1
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This simplifies to:

r1 ð1  bÞ
I i ¼
1gM H
1  g1

2. The M-government chooses gM M

1 by maximizing its objective function wrt. g1 . As regions do
not account for their contribution to finance matching transfers (N is large), the FOC of the
M-government writes:

     !
qW M qY 1 ðI 1 Þ qI 1 1 1 qI 1
¼ 1 þ ðb  cÞ  1 þc 1  M
M
qg1 qI 1 qgM 1
2 4 qg1
    !
   
qY 1 ðI 1 Þ qI 1 1 1 qY 1 ðI 1 Þ qI 1
þ  ðb  cÞ  þc  ¼0
qI 1 qgM 1
2 4 qI 1 qgM1

This yields the reaction function of the M-government:

ð1  bÞ
gM H
1 ¼ 1  g1 
1  2c

3. The H-government chooses gH H

1 by maximizing its objective function wrt. g1 . As regions do not
account for their contribution to finance matching transfers (N is large), the FOC of the
H-government writes:

     !
qW H qY1 ðI1 Þ qI1 1 1 qI1
¼  1 þ ðb  cÞ  1 þc 1  H
qgH
1
qI1 qgH 1
2 4 qg1
    !  
   
qY1 ðI1 Þ qI1 1 1 qY1 ðI1 Þ qI1 1
þ  ðb  cÞ  þ c   þ c 
qI1 qgH 1
2 4 qI1

qgH
1
4
 
   
qY1 ðI1 Þ qI1 1 qY1 ðI1 Þ qI1
 þc  ¼0
qI1 qgH 1
4 qI1 qgH 1

This yields the reaction function of the H-government:

gH M
1 ¼ b  g1
 JES 4. To determine the Simultaneous Move Nash Equilibrium, substitute gH
1 in the reaction function
of the M-government. This leads to:
41,6
ð1  bÞ
gM M
1 ¼ 1  b þ g1 
1  2c

878 There is no interior solution for this problem.

Two potential corner solutions need to be verified given the parameter restrictions:

gH M
1 ; g1 2 ½0; 1 :
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(a): gH M H M
1 ¼ 0 : in this case, g1 ¼ 1  ð1  bÞ=1  c=2 This in g1 ¼ b  g1 yields:

c
gH
1 ¼ ð1  bÞ 
2
40
1  2c

This is in contradiction with gH1 ¼0 .

(b): gM H
1 ¼ 0 In this case, the reaction function of the H-government yields g1 ¼ b . This in the
reaction function of the M-government leads to M:

 2c
gH
1 ¼ ð1  bÞ  o0
1  2c

The non-zero constraint is binding. Therefore:

gM
1 ¼0

The unique Simultaneous Move Nash Equilibrium of this game is a corner solution.
It remains to be shown that gH 1 is the first best matching rate of the H-government and
therefore implements I1H : With gM H
1 and g1 from step 4, the optimality condition of the regional
government 1, Ii ¼ r1 ð1  bÞ=1  gM
1  gH
1 leads to:

r1 ð1  bÞ
Ii ¼ ¼ r1
1b

Thus, gM H H
1 and g1 implement I1 as determined in step 4, the first best.
Proof of Proposition 3
(i) Solving the maximization problem of a rich region (type 2) yields:

r2  ð4  2b  cÞ
I2 ¼
4ð1  gM2 Þ

The maximization problem of the M-government for the rich region yields:

ð4  2b  cÞ
gM
2 ¼1
4ð1  2cÞ
 This matching rate implements the regional investment level that the M-government would Three-tier
unilaterally pick:
 structure of
c
I2M ¼ r1  1  or1
2
government

Investment in rich regions is below first best.

(ii) Solving the maximization problem of the poor region yields: 879
 
r  1b
I1 ¼ 1 M 2 H
1  g1  g1
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Similar to the approach in P2, we derive reaction functions:

1  b2
gM H
1 ¼ 1  g1  o0
1  2c

For the M-government and:

 
b
gH M
1 ¼ 1  g1  1 
2
for the H-government. Solving the simultaneous move game by plugging reaction functions into
one another shows again that there is no interior solution for this problem.
Two potential corner solutions remain to be checked given the restriction on parameters,
gH M
1 ; g1 2 ½0; 1 :
(a) gH M H M
1 ¼ 0. In this case, g1 ¼ 1  1  b=2=1  c=4 . This together with g1 ¼ 1  g1 
ð1  b=2Þ yields:
 
1  2b b
gH
1 ¼  1  40
1  4c 2

which is a contradiction.
(b) gM H
1 ¼ 0. In this case, g1 ¼ 1  ð1  b=2Þ ¼ b=2 . This in the reaction function of the
M-government yields:
 
M b 1  b2
g1 ¼ 1   o0
2 1  2c

The non-zero constraint is binding. Therefore, gM

1 ¼ 0 . This is the unique Simultaneous Move
Nash Equilibrium with gH M
1 ¼ b=2 and g1 ¼ 0, a corner solution. This holds for:
P 4 
kY k
gH
1  I 1 pc  Y 1 or
4

b
 r1
c ¼ P 42
c4
Y
k k
4  Y1

In this case oti40.

 JES Besides this unrestricted solution with large c, we also have to consider the case where c is
small. This distinction allows for two additional sub cases:
41,6
1 og1 1 p1  1  b=2=1  c=2 . In this case we know that:
M
(i): c small: holds for gH and gH

1  2b  c
gM H
1 þ g1 ¼ 1  c and I 1 ¼ r1 1 
12 2
880
The M-government implements its sub-optimal, desired level of investment. This holds if:

gH
1  I 1 X1  1  b=2=1  c=2  r1  ð1  c=2Þ:

Together, this yields:

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X
gH
1  I 1 X1  1  b=2=1  c=2  r1 ð1  c=2Þ4c 
4
k Y k =4  Y1

which can be simplified to:

b
r
coc ¼  P 4 2 1
 k
Y k
 Y1 þ r21
4

(ii): Finally, I M H
1 pI 1 pI 1 if these lies between the two margins determined above:

b b
 r1 r
P 42 ¼ c4c4c ¼  P 4 2 1
Y
k k
 Y1  Y
k k
 Y1 þ r21
4 4

However, note that the left hand side and the right hand side are evaluated at different levels of
regional investment (I1 ¼ r1, the first best on the left hand side and I1 ¼ r11/1c the regional
investment level that the middle level would unilaterally pick). To show that this range exists, we
need to show that:
P 4  P 4  
k Yk k Yk c
 Y1 jI1 ¼ r1 o  Y1 jI1 ¼ r1 1 
4 4 2

With the production function defined in Section 3, this can also be written as:
P4 P4     
k r1  ln ðr1 Þ
c
k r1  ln r1 1  2 c 
 r1  lnðr1 Þo  r1  ln r1 1 
4 4 2

By transforming left- and right-hand side, one can easily show that this inequality is indeed
true.

Corresponding author
Dr Andreas Kappeler can be contacted at: Andreas.KAPPELER@oecd.org

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