Optimal interregional redistribution and local budget rules with multidimensional heterogeneity

In this study we analyse optimal interregional redistribution and local budget rules in a two-region, two-period federation model. The two regions differ in privately observable discount factors and in publicly observable durability of local public goods. We address the question of whether the contributor region of redistribution should face a weaker borrowing constraint than the recipient region. The answer to this question is yes for two cases: (1) the patient region is the recipient and has public goods durability no greater than that of the impatient region; (2) the impatient region is the recipient with smaller public goods durability and the regional difference in discount factors is small. Otherwise, the recipient region may face a debt floor rather than a debt limit. These differentiated budget rules solve the self-selection problem under asymmetric information and decentralized borrowing and spending decisions, internalize the positive intergenerational externality durable public goods entail, and hence are constrained efficient. Moreover, optimal interregional redistribution schemes feature that the region with an undistorted intertemporal allocation of local public goods is always the contributor.