Inter-Governmental Transfers to Correct Spillovers:

In the fiscal federalism literature, very frequently mentioned objective of inter-governmental transfers is on the ground of internalising externalities. When public service is provided by one state but also enjoyed by the non-residents, it is called spillover of benefits. The particular state while deciding about the amount of public services to be provided ignores this benefit accruing to non-residents. If local residents are taxed only according to the benefits they receive then this will result in allocation of resources to collective consumption which is below optimum if all benefits were taken into account. The inter-governmental transfers are designed to handle such spillover of services provided by the states. These transfers need to be specific purpose in nature requiring matching contributions from the states. The matching contribution is determined on the basis of externality generated by the various public services.