February 25, 2016

How Federal Cash Harms State Governance

Jason Sorens

Senior Affiliated Scholar
Summary

Evidence suggests that intergovernmental transfers can adversely affect the total level of government spending, government debt, the tax burden, government efficiency, public knowledge about government, and economic growth.

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Americans have long debated the proper role of the central government, and for good reason: Today, state and local governments receive between a fifth and a third of all their revenue from the federal government. As I argue in a new paper, the evidence suggests that intergovernmental transfers like these can adversely affect the total level of government spending, government debt, the tax burden, government efficiency, public knowledge about government, and economic growth.

Progressive jurist Louis Brandeis praised the states as "laboratories of democracy" that can try out policy experiments. But as seven out of nine Supreme Court justices recognized in NFIB v. Sebelius, the strings attached to federal grants can effectively prevent states from making autonomous policy choices. That case involved (among other issues related to the Affordable Care Act) the federal government's threat to cut off all Medicaid funds to states that failed to expand the program's eligibility requirements, a restriction the Court considered unconstitutionally coercive given how much state budgets rely on Medicaid funds. 

Yet the bigger problem with grants may be that they empower state governments and loosen their accountability to their own voters. Windfalls of federal money arrive even if state residents don't think the programs funded this way are a good investment, and such grants are an attractive target for voracious interest groups. By contrast, when states have to get revenue from their own taxpayers, they have to pay attention when workers and businesses leave because of shoddy public services or excessive tax burdens. Fiscal competition makes governments more efficient.

In my paper, I examined all the peer-reviewed statistical evidence I could find published over the last 20 years on the effects of intergovernmental grants on various measures of public well-being and civic health. The majority of studies found harmful effects, although, as you might expect, a new grant does reduce the recipient government’s tax burden in the present fiscal period. Here are some examples of the problems these transfers can cause.

Economists Russell Sobel and George Crowley find that federal transfers "ratchet up" state tax burdens in the long run, because states decide to keep funding programs even after federal grants decline. If they’re right, states that expanded Medicaid will eventually face higher tax burdens when federal funding declines.

Countries where state and local governments depend on grants and shared revenues (over which they have no control) have much bigger government-debt problems whenever state and local governments are allowed to borrow, as in the United States. Stanford University political scientist Jonathan Rodden suggests that grants feel like a blank check to state governments, causing them to overspend and expect bailouts.

University of Pennsylvania economist Robert Inman (working from numbers developed by Brown University's Brian Knight) estimated that 40 cents out of every dollar spent in federal highway grants is deadweight loss, or waste.

"Equalization grants" are particularly bad. This type of grant redistributes income away from richer areas to poorer ones. Many states have equalization grants for public schools. The bulk of the evidence shows that equalization grants to localities raise overall local taxes in the long run, reduce public-sector efficiency, and impede voter control of government.

Equalization programs are so pernicious because they punish success, according to Stanford University political scientist Barry Weingast. A local government can get more money in grants, allowing it to reduce unpopular taxes, by killing its own economy.

Interestingly, there is even some evidence that grants reduce voter knowledge. A study of Spain looked at regions that had taken different approaches to decentralization; in areas where governments had to fund their own programs from their own revenues, voters became more informed about the division of program responsibilities between governments."

And lastly, the only study to date that has looked at the effect of grant-fueled spending on economic growth has found a negative effect.

To be sure, grants can sometimes serve a useful role in a federal system. When state or local governments' decisions can significantly affect people living outside their territory, it may be useful for neighboring or higher-level governments to pay them to make better decisions. For instance, invasive-species and pollution-control efforts might have benefits beyond one jurisdiction’s borders.

But the evidence on intergovernmental transfers suggests that American programs need reform. For some, the upshot of these results might be that the federal government needs to directly administer important programs rather than paying states to do so. For others, the main lesson might be that the federal government should reduce these grants and let states choose whether and how to fund their programs.

Our neighbor to the north, Canada, provides an example of partially successful reform. There, the federal government has allowed provinces to reclaim "tax points" by reducing federal income taxes — in other words, federal taxes decrease by a certain percentage, and provincial taxes increase by an equivalent amount — so that provinces may fund health and social programs as they desire.

Regardless of which direction the United States takes, there is a strong case to move away from the current, convoluted "kludgeocracy" of federal-state cost-sharing for large spending programs.

Americans have long debated the proper role of the central government, and for good reason: Today, state and local governments receive between a fifth and a third of all their revenue from the federal government. As I argue in a new paper, the evidence suggests that intergovernmental transfers like these can adversely affect the total level of government spending, government debt, the tax burden, government efficiency, public knowledge about government, and economic growth.

Progressive jurist Louis Brandeis praised the states as "laboratories of democracy" that can try out policy experiments. But as seven out of nine Supreme Court justices recognized in NFIB v. Sebelius, the strings attached to federal grants can effectively prevent states from making autonomous policy choices. That case involved (among other issues related to the Affordable Care Act) the federal government's threat to cut off all Medicaid funds to states that failed to expand the program's eligibility requirements, a restriction the Court considered unconstitutionally coercive given how much state budgets rely on Medicaid funds.

 

Yet the bigger problem with grants may be that they empower state governments and loosen their accountability to their own voters. Windfalls of federal money arrive even if state residents don't think the programs funded this way are a good investment, and such grants are an attractive target for voracious interest groups. By contrast, when states have to get revenue from their own taxpayers, they have to pay attention when workers and businesses leave because of shoddy public services or excessive tax burdens. Fiscal competition makes governments more efficient.

In my paper, I examined all the peer-reviewed statistical evidence I could find published over the last 20 years on the effects of intergovernmental grants on various measures of public well-being and civic health. The majority of studies found harmful effects, although, as you might expect, a new grant does reduce the recipient government’s tax burden in the present fiscal period. Here are some examples of the problems these transfers can cause.

Economists Russell Sobel and George Crowley find that federal transfers "ratchet up" state tax burdens in the long run, because states decide to keep funding programs even after federal grants decline. If they’re right, states that expanded Medicaid will eventually face higher tax burdens when federal funding declines.

Countries where state and local governments depend on grants and shared revenues (over which they have no control) have much bigger government-debt problems whenever state and local governments are allowed to borrow, as in the United States. Stanford University political scientist Jonathan Rodden suggests that grants feel like a blank check to state governments, causing them to overspend and expect bailouts.

University of Pennsylvania economist Robert Inman (working from numbers developed by Brown University's Brian Knight) estimated that 40 cents out of every dollar spent in federal highway grants is deadweight loss, or waste.

"Equalization grants" are particularly bad. This type of grant redistributes income away from richer areas to poorer ones. Many states have equalization grants for public schools. The bulk of the evidence shows that equalization grants to localities raise overall local taxes in the long run, reduce public-sector efficiency, and impede voter control of government.

Equalization programs are so pernicious because they punish success, according to Stanford University political scientist Barry Weingast. A local government can get more money in grants, allowing it to reduce unpopular taxes, by killing its own economy.

Interestingly, there is even some evidence that grants reduce voter knowledge. A study of Spain looked at regions that had taken different approaches to decentralization; in areas where governments had to fund their own programs from their own revenues, voters became more informed about the division of program responsibilities between governments."

And lastly, the only study to date that has looked at the effect of grant-fueled spending on economic growth has found a negative effect.

To be sure, grants can sometimes serve a useful role in a federal system. When state or local governments' decisions can significantly affect people living outside their territory, it may be useful for neighboring or higher-level governments to pay them to make better decisions. For instance, invasive-species and pollution-control efforts might have benefits beyond one jurisdiction’s borders.

But the evidence on intergovernmental transfers suggests that American programs need reform. For some, the upshot of these results might be that the federal government needs to directly administer important programs rather than paying states to do so. For others, the main lesson might be that the federal government should reduce these grants and let states choose whether and how to fund their programs.

Our neighbor to the north, Canada, provides an example of partially successful reform. There, the federal government has allowed provinces to reclaim "tax points" by reducing federal income taxes — in other words, federal taxes decrease by a certain percentage, and provincial taxes increase by an equivalent amount — so that provinces may fund health and social programs as they desire.

Regardless of which direction the United States takes, there is a strong case to move away from the current, convoluted "kludgeocracy" of federal-state cost-sharing for large spending programs.