The architecture of federations: Constitutions, bargaining, and moral hazard

• One region in a federal system pursues a policy project with spillovers.
• Setting: Moral hazard, endogenous grant system, interregional bargaining
• We ask whether centralization or decentralization is best mode of governance.
• Show: Only decentralization solves moral hazard, achieves first best.
• Why? Grants align default project size, and investment incentives.

The paper studies a federal system where (a) a region provides non-contractible inputs into the social benefits from a public policy project with spillovers to other regions, and (b) where political bargaining between different levels of government may ensure efficient decision making ex post. Allowing intergovernmental grants to be designed optimally, we ask whether project authority should rest with the region or with the central government. Centralization is shown to dominate when governments are benevolent. With regionally biased governments, both centralization and decentralization yield inefficiencies and the second-best institution depends on parameter values if political bargaining is prohibited. When bargaining is feasible, however, the first best can often be achieved under decentralization, but not under centralization. At the root of this dichotomy is the alignment of decision making over essential inputs and project size under decentralized governance, and their misalignment under centralization.