Each federal state consists of several regions, which are linked by a high degree of mobility of individuals and firms. The high degree of interregional mobility causes allocative problems that cannot be found in a unitary state. The problem of an efficient allocation in a federal state – for a politically predetermined jurisdictional structure – is mainly a problem of the efficient locational pattern. Therefore, the first basic objective of this chapter is to derive the efficient interregional allocation of mobile factors of production, firms, and individuals. Of course, efficiency in a federal state also requires the efficient provision of public goods and factors, but this is achieved in much the same way as in a unitary state. Differences only arise if regions take on the responsibility of supplying some kinds of public goods for which consumption also extends to nonresidents. To achieve the efficient allocation in this case, these spillover effects must be internalized.

The second objective of this chapter is to study whether the efficient allocation can be achieved by decentralized decisions of firms and individuals. The regional tax system is of particular importance. It affects firms' decisions to employ mobile factors of production and is an important determinant of the locational choice of firms, and households make their residential choice dependent on the tax system. A set of tax instruments that allows regions to achieve the efficient locational pattern and simultaneously finance the efficient amount of public services will be called an efficiency-supporting or simply a complete tax system.