One of the key questions that arise in discussions of education decentralization, is how federal education resources should be allocated among the various states, and within states, among communities or schools. In general, there are two approaches: (1) bilateral negotiations between the federal government and states with little transparency as to the rules, and (2) formula-based distribution. The authors show that, based on econometric analysis on federal education transfers data in Mexico, the former approach can lead to allocation results that appear contrary to stated policy objectives like equity improvement and greater social inclusion in education. The authors then argue that contrary to common belief, the use of capitation, or per student allocation can improve not only efficiency but also equity. They present a theoretical model to analyze this hypothesis. The authors discuss several variations of the capitation formula, and present an analysis of the characteristics of the winners, and losers of their application, using Mexico as an illustration.