Efficiency and the optimal direction of federal-state transfers

It seems to be widely believed that the case for centralizing revenue-raising is stronger than that for centralizing expenditure decisions, so that federal governments should typically make transfers to lower-level (state) governments. This paper argues, however, that pure efficiency considerations may plausibly point in exactly the opposite direction. This arises because of a vertical fiscal externality: the typical state may neglect the impact that its tax decisions have on the federal tax base. The optimal federal response is to internalize this distortion of state decisions by means of offsetting subsidy on the common tax base, the financing of which may plausibly require transfers from the states.