Vierteljahrshefte zur Wirtschaftsforschung

In every federal state the question has to be answered how to internalise spillovers. This article hypothesises that politicians choose the instrument with the lowest transaction costs. After the German constitution (Grundgesetz) came into effect a lot of institutional reforms were implemented to avoid or reduce spillovers at the state level. The German constitution implies comparatively low transaction costs for a centralisation of legislation. The same holds for fiscal grants, so the federal government makes wide use of them to influence decisions of the state governments. The joint tasks (Gemeinschaftsaufgaben) are employed to concentrate projects in one state at a low level of transaction costs. In an upcoming reform of the German federal system aiming at more competition among the states the transaction costs ought to be considered. A more frequent use of bargaining to internalise spillovers bear the danger of raising transaction costs, and hence limiting competition at the state level.