Inter-state transfers for cost differences in federations with population mobility and natural resources

Abstract

The Australian system of horizontal scal equalization (HFE) transfers output from low to high cost states. This paper develops a standard model of a federation with an imperfectly mobile population and states which capture economic rents from natural resources and recycle the revenue on the basis of residency. A federal agency, which can be thought of as mimicking the role of the Commonwealth Grants Commission, chooses an inter-state transfer to maximize national social welfare. The contribution of the paper is to show that under the assumptions of the model, the optimal transfer to a state is increasing in its costs, for given costs in other states. This supports the notion of inter-state transfers in favour of high cost states. However, the result does not necessarily validate the magnitude of transfers that we see in practice in the Australian federation.