Interregional transfers, group loyalty and the decentralization of redistribution

We study the relative merits of centralized and decentralized redistribution in a political economy context assuming cross-regional heterogeneity in average income and identity. While centralizing redistribution allows to pool and redistribute resources at the country level, it may decrease the degree of solidarity in the society as a result of group loyalty. We show that total welfare maximization is closely linked to the minimization of income inequality within and between regions. Analyzing separately two particular cases under direct democracy—no interregional inequality and no group loyalty—we stress the existence of a scope effect and a pooling effect of centralized redistribution, respectively. In both cases, centralization welfare-dominates decentralization, from which it follows that the rationale for decentralizing redistribution only arises when the two sources of cross-regional heterogeneity interact.