<p>We analyze optimal budget institutions for local governments in a scenario where local public goods generate positive interregional externalities, such as environmental protection. There is a central government (referred to as the center) and two regions. Each region possesses private information regarding the extent of beneficial spillovers it experiences from the public goods provided by the other region. To achieve constrained efficiency, it is necessary to address these externalities while also tackling the center’s self-selection issue in the presence of asymmetric information. One way to implement the optimal solution under asymmetric information is through a simultaneous-move equilibrium. The center can set a minimum debt level for the region that generates higher spillovers and impose a Pigouvian tax on the region benefiting more from spillovers, subsequently transferring the revenue as a subsidy to the other region. Alternatively, a sequential-move equilibrium can implement the asymmetric information optimum with the additional condition that the follower region’s optimal debt choice is concave in the leader region’s debt choice.</p>