The efficiency performance of democratic federalism turns on constitutional assignment and representation. As a guideline to assignment, local governments will be most efficient for those services, taxes, and regulations which benefit local populations and which have no significant positive or negative spillovers onto non-residents. For goods with significant economies of scale in production or consumption, for taxes which alter the spatial allocation of economic resources, and for services and for regulations with economic spillovers, allocation by the central government is preferred (Oates 1972).

Democratic federalism adjusts representation to the central legislature to improve the efficiency performance of the central government in allocating its assigned tasks. Representative legislatures must overcome a fundamental structural defect of democratic choice: the propensity of the majority-rule process to cycle from one policy outcome to another (Arrow [1951] 1963). If legislatures are to reach decisions, additional legislative institutions must be discovered for overcoming this inherent instability. In democratic federalism a norm of deference may arise to control such instabilities (Weingast 1979). Each legislator defers to the preferred policies of all other legislators, provided the other legislators defer to the legislator’s own policy requests. Unfortunately, large legislatures operating under a norm of deference run a significant risk that their chosen policies will be economically inefficient. In a national legislature financed by national taxation there results a cross-subsidy from taxpayers nationally to the residents of the jurisdiction receiving the centrally provided public good. The incentive for the legislator selecting a project and facing such a subsidy is, of course, to ask for too much of the good. In one important instance, however — the case of Samuelson public goods or goods with positive spillovers — the incentive for local representatives to demand too much of the good may promote efficiency. In this case, the legislature’s cost-sharing of local projects encourages local representatives to demand more of a nationally beneficial public good than they would if they had to finance the good on their own. Tax-sharing in the national legislature acts as a subsidy for local representatives to provide more of nationally beneficial public good. As a guideline to representation in democratic federalism – precisely efficient representation is generally not possible with multiple public goods – the legislature should approximate in size the average ratio of national to local benefits for the public goods and spillovers it has been assigned (Inman and Rubinfeld 1997). Under this guideline, central government legislatures assigned responsibility for important national public goods should be large, while legislatures assigned responsibility for local goods should be small.