Subsidised transport services in a fiscal federation: Why local governments may be against decentralised service provision

In this paper we consider a fiscal federation and study the effects of decentralised provision of loss-generating public services with benefit spillovers to other regions. We use public transport provision across administrative borders as a prototype example. We show in a formal model that local governments might be better off when a higher-level government or a neighbouring region provides these services, and even privatisation to a monopolist can be preferred over decentralisation. Our model reveals that these results are governed by a variant of the tax exporting mechanism that applies to subsidised services, i.e., the possibility that local consumers can exploit spillover benefits without contributing to the subsidy burden of service provision. Public transport provision is one of the large sectors of public policy where decentralisation could provide social benefits, but, as the paper reveals, the need for subsidies generates a genuine conflict of interest between the governments involved.