Why Delegate?: An Incomplete Contracting Approach to Environmental Federalism

Abstract

This paper examines the optimality of environmental regulatory delegation when neither output levels nor effort levels are contractible. The key trade-off is that while the federal government is able to internalize externalities, the state governments have preferences that are better aligned with local welfare. I compare four decentralization scenarios, each corresponding to a different allocation of output power and effort power between the federal and state governments. A central finding is that conjoint federalism (the federal government chooses output while the states choose effort), which is the regulatory structure used for many environmental regulations in the United States, tends to be the least efficient form, while a reverse form of delegation tends to be the most efficient.

Keywords: Environmental federalism, incomplete contracts, delegation, regulation, federalism

JEL Classification: H77, H10, Q58, H51, D62, L51, D70, D20