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The purpose of this paper is to study how the central government can use well-known game-theoretical concepts in order to stimulate provision of local public facilities.

The authors use the classical adverse selection framework to discuss how the central government can use investment transfers as efficiently as possible to stimulate increased provision of local public facilities.

The benefits of local public facilities, such as kindergartens, schools, and primary healthcare institutions are greater than what each local government takes into account. Consequently, the central government, which maximizes social welfare in total, wants more local public facilities than the individual local government find optimal to supply. The central government thus would want to stimulate additional provision of local public facilities using contracts where local governments receive a transfer as compensation for increasing their supply. Since local governments differ regarding their efficiency in supplying facilities, the required amount of facilities and the corresponding transfer size should be allowed to vary across local governments.

Almost all countries are organized with multiple tiers of government, and local governments are important providers of many important welfare services. After labor, facilities are probably the second most important input in production of local public services. This paper offers insights into how the central government can efficiently stimulate the production of local public facilities.