Journal of Global Economics

Optimal Fiscal Equalization under Asymmetric Information

Abstract

Weihong Huang, Yang Chen and Weiwei Song

This paper focuses on the problem of how to design optimal fiscal equalization with different fiscal needs among regions with asymmetric information. In the full information condition, our results suggest that an efficient transfer scheme should not simply fully equalize the fiscal need among regions by redistributing among regions. Instead, it should equalize the marginal cost of public funds across regions, in which the social cost of raising tax revenues can be minimized. In the asymmetric information condition, in order to eliminate the incentive of rich regions mimicking poor regions, the second best policies designed for poor regions are distorted while policies for rich regions remain the first best condition. Thus, rich regions get some informational rents.