Optimal Profit Allocation Mechanisms for Economic Unions Under Adverse Selection and Moral Hazard

Economic unions, such as American states, Canadian provinces, or EU countries, face the problem of how to allocate union-wide corporate profits among its individual members when each member retains some taxing authority. This paper studies the normative properties of two common types of allocation mechanisms, separate accounting and formula apportionment, when firms have private cost information and make investment decisions union members cannot observe. The optimal separate accounting and formula apportionment mechanisms are derived. Their differences reflect a trade-off between firms earning fewer rents versus productive efficiency. The welfare implications of this trade-off are examined. The optimal separate accounting mechanism generates higher expected union welfare when upstream tax rates are low.