Public Finance, 2nd Edition

tion of national services or private information. The question remains

whether local autonomy can be justiWed in a Wrst-best environment when

the national government is the only government allowed to make social

welfare rankings, and it has perfect knowledge and access to whatever policy

tools are necessary to generate Wrst-best allocational decision rules. The

answer would appear to be no, yet local autonomy does seem more appropri-

ate for public services that are limited in scope, all the more so when Oates'

perfect correspondence happens to obtain within jurisdictions that already

exist. Stigler's twin axioms for allocating the functions of governmentÐ

choose the lowest level jurisdictions consistent with allocational eYciency

and preserve states' rightsÐremain compelling despite the formal implica-

tions of Wrst-best theory. Is it possible, therefore, to resurrect Wscal federalism

as an optimal governmental structure without introducing speciWc second-

best assumptions? In our view, the answer is ``yes:'' Federalism can be

justiWed on distributional grounds, but this involves a line of argument that

has not received much attention in the theoretical literature on Wscal federal-

ism.

OPTIMAL FEDERALISM AND THE DISTRIBUTION FUNCTION

The literature on the optimal structure of a federalist system of governments

is virtually unanimous in assigning decisions on income distribution to the

national government.

6

According to the conventional wisdom, allowing

redistribution by lower level (``local'') governments in the Wscal hierarchy is

formally inconsistent with social welfare optimization, whether one assumes

that people are immobile or fully mobile across local jurisdictions.

We happen to disagree with the conventional analysis on this point. In

our view, a federalist system is not only formally consistent with social

welfare maximization when it contains lower government redistributions,

but it also requires local redistributions to have meaning as an optimal

Wscal system from the mainstream perspective. A review and criticism of

the conventional position is useful before developing our preferred model

of federalism.

Redistribution, the Competition Problem, and

Potential Incompatibilities

Assume W rst that people are mobile, and suppose that one local gov-

ernment tries to redistribute from its rich to its poor citizens, but only one.

6

A notable exception is Mark Pauly, ``Income Redistribution as a Local Public Good,''

Journal of Public Economics, Vol. 2, 1973. Pauly develops a model based on the Hochman

and Rodgers notion of pareto-optimal redistributions (Chapter 10), in which, under certain

29. OPTIMAL FEDERALISM: SORTING THE FUNCTIONS OF GOVERNMENT 841