September 17, 2010

Do Intergovernmental Grants Create Ratchets in State and Local Taxes?

Research Summary
  • George R. Crowley

  • Russell S. Sobel

Key materials
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Every dollar in temporary federal grants leads to 40 cents of tax increases. Economists have long suggested the existence of a “flypaper effect,” wherein federal money given to states prompts additional spending. However, empirical research shows that federal grants to states also leads to additional state and local taxes when federal spending decreases.

As Milton Friedman pointed out, there is nothing as permanent as a temporary government program. As a consequence, when states accept federal aid to create or expand public programs today, they will inevitably be forced to decide whether to cut the program or raise taxes when federal aid ends.

Empirical evidence from the previous 15 years shows that tax increases are the likely result, averaging around 40 cents in state and local tax hikes for every federal grant dollar.