Traditional fiscal federalism theory postulates that devolution for the provision of local public goods increases welfare. However, most of the services offered at local level are local impure public goods whose characteristics may prevent devolution from being efficient. Our paper shows that devolution is the optimal choice only for local impure public goods. For an environment characterised by coordination and asymmetry of information problems, we propose the optimal grants-in-aid formula that Central Government should use to reduce welfare losses and we compare it with what suggested by the mainstream literature. Finally, we show under which conditions devolution should be preferred to a centralised solution. From a policy point of view, our paper may explain the heterogeneity in the choices made by countries in terms of devolution in the provision of merit and impure public goods.
Keywords: Devolution; Grants-in-aid; Impure public goods; Spillovers.