Should Intergovernmental Transfers Provide Insurance to the States?

This paper studies the constrained efficient intergovernmental transfer contract between the central government and the states in a federal economy. We consider an environment with moral hazard, incomplete enforceability, and date-0 negotiation costs. The interaction of moral hazard and incomplete enforceability may imply that when the state's resources are "low enough," it is constrained efficient that the state gets a lower utility level than in autarky. When negotiation costs are considered, the state might not accept the contract. More importantly, the degree of acceptance of the contract by the state is not monotonically determined by the state's fiscal situation.