In order to derive an intervention scheme that induces regions to choose an efficient allocation or an optimal income distribution when regional decisions fail to do so, we have assumed in preceding chapters that the central government has all necessary information. However, as explained in Section 1.3, there is a widespread belief that regional governments are better informed about those basic economic variables that determine the optimal provision of local public goods and the optimal income redistribution: the tastes and income levels of their constituents. In addition, the central government cannot directly observe the efforts of regional governments to achieve a certain regional income level or a certain amount of regional tax revenues. This chapter therefore takes a closer look at the consequences of asymmetric information between the regions and the center.

Within this environment, two problems arise. The first is the problem of adverse selection. Regions may hide data that is necessary for the optimal central government intervention, so the center must design its intervention scheme such that it pays for the regions to self-select. The second problem is the issue of moral hazard. Regions may influence by their own efforts – public infrastructure investments, bureaucratic efforts, or tax enforcement – economic variables that the center can observe. Regions thereby try to avoid becoming a net contributor to the central government budget. To capture both phenomena, this chapter builds on contributions to the literature on adverse selection and efficient taxation – most notably, on Stiglitz (1982) – and on the literature on incentive problems, as in Laffont and Tirole (1993).