Federations, Constitutions, and Bargaining∗

This paper investigates public policies within a federal system in a framework where constitutions are endogenous, and where regional decisionmakers face no frictions in negotiating policy outcomes with each other. We ask whether centralization or decentralization is the appropriate mode of governance under the optimal constitution. This question is addressed in a simple setting where one federal region can pursue a political project that causes spillover effects on other jurisdictions. The initially chosen federal constitution specifies not only the allocation of authority over policy choice (decentralization vs. centralization), but it also puts an optimal grant system in place. However, regional investments into costs and benefits of subsequent policy projects are not directly contractible, which seems realistic and adds a crucial moral hazard dimension. As a benchmark, we first show that centralization is always dominant when governments are benevolent. This result changes dramatically when regional delegates pursue the interests of their constituencies instead: while the feasibility of political bargaining often leads to first best decisions under decentralization, this is not true under centralization where inefficient underinvestment is unavoidable