This article examines the optimal structure of intergovernmental grants, using a model that extends the theories of optimal taxation and production to a federal system. The theoretical model assumes a two-tiered system of state and federal governments, with the federal government choosing grants to the state governments. Application of numerical methods allows calculation of the optimal grant structure under a range of assumptions regarding individual preferences, government production, and state and federal social welfare functions. The optimal grant structure has some features suggested by the traditional literature, such as the inferiority of conditional lump-sum grants. The results, however, also suggest important modifications in the traditional grant prescription. Not surprisingly, the objectives of all the governments matter in determining the magnitude and structure of grants. More significantly, the matching rate on conditional open-ended matching grants is no longer determined solely by externalities in state production. Instead, the matching rate reflects the distributional and allocative goals of all the governments, and it is sensitive to the distortions introduced by federal taxes.
