Our paper presents a model of decentralized leadership with fiscal equalization and imperfect economic integration. The degree of trade integration (reflected by trade costs) turns out to have an effect on both the state tax rates and the ex-post vertical equalization transfers. Our main results are the following: Ex post vertical transfers are welfare deteriorating for low levels of trade integration while they are welfare improving compared to tax competition when trade integration is high enough. However, when public goods are highly valued by the citizens of the federation, ex post transfers are always welfare enhancing.