What is fiscal federalism

This may include allocating goods, employment levels, and income rates on a broad level, so that all citizens have relatively equal access to the same wages, economic opportunities, and consumer goods. Other provisions may include correcting vast market failures through economic stimulus. In this traditional model, the role of the decentralized or regional government is much more specific to the needs of the jurisdiction.

People in Arkansas, for instance, will probably have different needs than those in Oregon. A strong system of regional governments can help ensure that the individual needs of each jurisdiction are met, while the central government tends to manage issues on a much broader, macroeconomic level. With aid programs, policy decisions are often made by unelected officials in Washington rather than by elected officials locally.

Aid programs move decisions away from the nation's more than , elected state and local officials to thousands of unknown and inaccessible federal agency employees. In theory, the elected members of Congress oversee aid programs, but they have delegated much of their power to the federal bureaucracies.

If you do not like a policy in your child's public school, you can voice your concern to local officials. But if the policy was imposed by Washington, you will have a hard time making your concerns known. Furthermore, the sheer size of the federal government works against democratic involvement. There is empirical evidence that "both citizen influence and effort increase as the size of the government declines.

The federal government controls a substantial share of state policy. Federal aid accounts for one-quarter of state and local government revenues. That share increased from one-third in the mids to four-fifths today. But by , none of the 22 areas were exclusively state controlled, and nearly all areas were a heavy mix of federal and state. The largest expansion in federal control occurred during the s and s.

Interestingly, a separate study using a similar method looked at Canada and found that since that nation's founding in , the government's structure has become slightly more decentralized. The upshot is that centralization is not inevitable. Canada is a high-income democracy with more decentralized governance than the United States. In the United States, state leaders do not control a substantial part of their own governments anymore. But often they are just deciding which local officials get to implement the dictates of distant and insulated federal bureaucrats, whom even Congress can't control.

Many state employees really "work for" the federal government because that is who funds their salary in full or in part. State agencies know that "even if only a small percent of an employee's salary or program resources comes from federal aid, loss of that portion can result in a job loss or program cutback.

Organizations representing state employees funded by federal aid routinely lobby for federal policies counter to the positions of the elected officials of their own states. Former Nebraska governor Ben Nelson expressed his dismay at the limitations of his office: "I honestly wondered if I was actually elected governor or just a branch manager of the state of Nebraska for the federal government. Constitution guarantees to each state a "Republican form of government," meaning a representative democracy, but that promise is undermined when the states are just "branch managers.

Federal aid requirements have spawned the creation and expansion of state and local government agencies. As noted, these agencies relying on aid often have substantial autonomy from state elected officials, and so aid has fragmented state government horizontally.

At the same time, federal aid has jumbled American government vertically. Originally, the three levels of government were like a tidy layer cake with each layer handling separate functions.

Citizens knew whom to praise or blame for policy actions. But with the rise of aid, American government has become like a marble cake with responsibilities mixed across layers.

In his budget message, Reagan argued, "During the past 20 years, what had been a classic division of functions between the federal government and the states and localities has become a confused mess. In the s, one of the concerns of the Anti-Federalists about the U. Constitution was the complexity it would add to government.

Complex governments "seem to bid defiance to all responsibility. The Anti-Federalists were right. Today's marble cake structure of government allows politicians to point fingers of blame at other levels of government when failures occur.

That was clear in the aftermath of Hurricane Katrina in , and it was evident during the water crisis in Flint, Michigan, a few years ago. When every government has a hand in an activity, no government takes responsibility for failures.

Budget expert James Capretta noted that "Medicaid's current federal-state design also undermines political accountability. Neither the federal government nor the states are fully in charge. The ACIR noted that the aid system "has become too big, too broad, and too deep for effective operation or control.

Where all responsibilities are shared, no one is truly responsible. And, if everyone is responsible for everything, none can fulfill their obligations. Political scientist Steven Teles coined the word "kludgeocracy" to describe a system in which the "complexity and incoherence of our government often make it difficult for us to understand just what the government is doing.

In many policy areas, the federal government's role appears to be crucial because state and local governments and the private sector are not currently addressing public needs. But that is often the case only because the federal government has partly or fully displaced crowded out state, local, and private efforts.

For better or worse, the states have usually led the way on expansions in government services over the past century. The Pennsylvania Turnpike opened in , and its success prompted more than a dozen states to launch their own superhighway programs.

Section 3 discussed the extent to which federal spending either displaces or adds to the amounts that states spend on targeted activities. Federal spending on interstate highways likely did increase overall highway spending initially and only partly crowded out state efforts.

But, either way, federal aid for highways has come with negative effects, such as raising construction costs, misallocating investments, and creating bureaucracy. As a separate matter, a less examined phenomenon is how federal aid induces state and local governments to crowd out or displace the private provision of services.

This negative effect of federal aid is clear in the provision of transportation infrastructure. Federal aid has crowded out private highway bridges. A survey found that nearly two-thirds of toll bridges in the United States were privately owned. Because private bridge owners did not receive subsidies and were already suffering from revenue declines during the Great Depression, many succumbed to government takeovers.

Urban transit systems in most American cities were privately owned and operated until the s, but then the private share started falling rapidly. Of the systems in the largest U. The nail in the coffin for private transit was the Urban Mass Transportation Act of , which provided federal aid to government-owned bus and rail systems. That encouraged state and local governments to take over private systems, and a century of private transit investment came to an end.

A similar thing happened in aviation. About half of U. These airports were successful and innovative, but they lost ground from unfair government competition. City governments could issue bonds exempt from federal tax to finance their own airports, giving them a financial edge over private airports. Private airports had to pay taxes while government airports did not. The federal government began handing out aid to government-owned airports during the New Deal, and then the Airport Act of began regular federal aid funding of government-owned airports.

Today, virtually all U. Sadly then, during the 20th century, state and local governments—supported by federal aid—displaced entrepreneurs from major parts of America's transportation industries. Federal aid for government infrastructure, combined with the tax-free status of government bonds, has created a strong bias in favor of government ownership. The effect of the bias is clear when you consider that the global privatization trend in airports of recent decades has mainly bypassed the United States.

Federal aid has supported the states in crowding out private provision in other areas. The expansion of Medicaid has crowded out private healthcare. Estimates vary, but roughly every two persons added to the program has reduced private health coverage by one person. Government-supported schools have long crowded out private schools, and federal aid has exacerbated the problem.

School-choice programs are on the rise in many states, but generally parents wanting to escape a poor-quality public school have had to pay private tuition on top of paying taxes to fund the public system. One of the earliest federal aid programs, passed in , was for subsidizing vocational schools—but only schools owned by governments. As a last example, increasing federal aid for natural disasters may be crowding out state, local, and private efforts.

After the Northridge, California, earthquake, U. House and Senate reports concluded that the availability of federal aid had encouraged state and local governments to neglect disaster preparation and mitigation. In the wake of Hurricane Katrina in , Florida governor Jeb Bush warned against increasing federal intervention. He said, "As the governor of a state that has been hit by seven hurricanes and two tropical storms in the past 13 months, I can say with certainty that federalizing emergency response to catastrophic events would be a disaster as bad as Hurricane Katrina.

When states need help during natural disasters, a better alternative than federal aid is aid from other states. Indeed, the states do help each other with manpower and resources under the Emergency Management Assistance Compact EMAC , which expedites the legal process of mutual aid. Local governments also share police and fire assets during emergencies, and electric utilities across the nation routinely aid one another with crews and equipment after storms. The EMAC is one of more than interstate compacts in place today.

When tackling problems that affect multiple states, policymakers should consider state cooperation first before they call for a top-down imposition from Washington.

As Governor Bush noted, when the federal government gets involved, it displaces the innovation, creativity, and knowledge that come with nonfederal efforts. The rise of federal aid and the centralization of power in Washington have coincided with falling trust in the federal government. Public polls show that the share of people who trust the federal government has plunged from about 70 percent in the s to about 20 percent today.

Polls find that general anger toward federal policies has increased. A poll by Pew Research found that 22 percent of Americans feel "angry" about the federal government, and an additional 57 percent or so feel "frustrated" by it, leaving just 18 percent "contented. The rise in federal aid and top-down regulations have likely contributed to today's anger and partisan divisions by trying to force policy conformity on a diverse country. The aid system imposes one-size-fits-all policies on the nation when there is no national consensus.

The grassroots anger over the attempted imposition of Common Core school standards is a good example of the backlash against enforced conformity.

The cooperative federalism advanced by the nationalist school of federalism requires a national consensus on such issues, but there is no consensus. Requiring state electorates to implement sometimes hotly contested national policies appears to have considerably exacerbated national conflict in ways that threaten the institutional fiber of the republic.

Reviving competitive federalism by reducing federal intervention would help heal political divisions. Large majorities of Americans prefer state rather than federal control over education, housing, transportation, welfare, healthcare, and other activities.

For these reasons, there has been a shift in public opinion in recent decades in favor of decentralizing government power. The aid system does not deliver efficient public services, but rather delivers bureaucracy, overspending, and federal micromanagement. It undermines policy diversity and political accountability.

The states are entirely capable of funding and operating their own programs. President Reagan's executive order on federalism noted, "In most areas of governmental concern, the states uniquely possess the constitutional authority, the resources, and the competence to discern the sentiments of the people and to govern accordingly.

President Trump's most recent budget proposed small cuts to federal aid. But that proposed reform provoked a prominent liberal think tank to issue a study defending aid. The study's first sentence was, "Federal funds that go to state and local governments as grants help finance critical programs and services on which residents of every state rely. It is understandable that federal policymakers are eager to try and fix the nation's many ills.

But they should appreciate that the states can handle domestic policies by themselves and that federal intervention is often counterproductive. The optimism of previous decades about the ability of federal aid programs to efficiently solve state and local problems was misguided.

Congress should work with the Trump administration to identify and eliminate low-value federal aid programs. Over the longer run, the aid system should be fully phased out. Americans want more responsive and effective government, and they can get it by devolving power to the states and reviving competitive federalism.

Figure 1 uses counts from the Advisory Commission on Intergovernmental Relations for —, the Office of Management and Budget for —, the Congressional Research Service for —, and my own count for based on the OMB method.

See endnote Emma Wei assisted with the count. And see Paul H. Crowell Company, ; and Sam J. Ervin, Jr. In explaining the growth in aid to states, Inman says, "Congress as an institution for fiscal policy underwent a major transformation in structure from to , evolving from a legislative body dominated by a few major decision-makers with firm control over fiscal affairs to a largely decentralized forum of individual deal-makers each required to maximize his or her own net gain from legislative decisions.

Quoted in David B. There was a shift from the previous view that grants could efficiently solve externalities to the new view that rent-seeking, fiscal illusion, and bureaucratic behaviors better explained the structure of intergovernmental grants.

I included programs of type A, B, and C for state, local, and tribal governments, while excluding programs for private-sector recipients. Programs with zero obligations were excluded.

The Congressional Research Service provided a count for of 1, Most are categorical grants, which target a narrow range of activities and include detailed rules for states to follow. By contrast, block grants fund a broader range of activities and give states more flexibility.

See Iris J. The first book about the new and growing federal aid system published in captured the political appeal of federal funding: "The voters have clamored loudly for better standards of service—more and better schools, more and better teachers, more and better roads.

At the same time they have voiced no less insistently their demand for lower taxes. State legislators. One of the richest finds has been the federal treasury. Crowell Company, , p. Some states have large unfunded obligations in their worker retirement plans, and so they are not fiscal saints.

However, state and local debt and unfunded obligations are a smaller problem than federal government debt and unfunded obligations. Also, some states are quite prudent and have very low debt and unfunded obligations. Christenson, Douglas L. In recent years a new literature on fiscal federalism has emerged that considers the performance and evolution of federal systems, taking into account such issues as principal-agent problems, economics of information, and the theory of contracts Oates , Weingast Researchers refer to this evolving literature as a second generation theory of fiscal federalism and the traditional fiscal federalism as first generation fiscal federalism.

This essay concentrates on first generation or traditional fiscal federalism, hereinafter referred to simply as fiscal federalism. Although the theory of fiscal federalism applies to many countries across the world, the tables below all describe the U. Government expenditure responsibilities can be divided into stabilization, distribution, and allocation functions. Fiscal federalism provides general guidelines for dividing these responsibilities among federal, state, and local governments based on the nature of the expenditure function and the relative capabilities of the different types of governments.

The stabilization function entails efforts to impact unemployment and inflation levels and stimulate economic growth. Stabilization tools include fiscal and monetary policies. As no state or local government is big enough to affect the overall level of economic activity, experts agree for the most part that the stabilization function is best left to the federal government. Experts agree that this function is usually best left to the federal government.

State or local efforts to redistribute income can be rendered ineffective because of the small geographic reach of these governments and their mobile populations. For example, efforts to redistribute income from high-income to low-income households could lead to a counterproductive out-migration of high-income households and in-migration of low-income households.

The allocation function concerns the production or provision of goods and services, such as national defense, university education, or garbage collection. Whether these functions should be provided by federal, state, or local governments depends upon a number of factors.

First, the geographic reach of service benefits must be considered. As the benefits of national defense are national in scope, this service is best left to the federal government. In contrast, the impact of fire protection is local, and can often be best provided by local governments.

Economies of scale per unit costs of production fall as the scale of production rises and externalities or spillovers whereby activities undertaken in one geographic area impact citizens in another area are factors that tend to make government goods and services best provided by larger units of government such as the federal government or state governments.

Diversity in demand is the most important factor favoring local government provision of government goods and services. Local governments can best tailor services to fit the needs of their citizens. Decentralized provision of government services also facilitates a natural laboratory in which innovations tried and proved successful by one government can be adopted by an entire state or the federal government.

For the most part, the division of expenditure responsibilities in the U. Thus, the federal government provides national defense, state governments provide highways and university education, and local governments provide police and fire protection and K—12 schools.

Whether measured as a percentage of total federal outlays, total state and local expenditures, or the national economy GDP , federal grants to state and local governments grew from to In the 's, largely because of the growth of the Medicaid program, an open-ended matching grant, federal grants to state and local governments began to grow again. From to federal grants to state and local governments fell in importance.

TABLE 3. The composition of federal aid to state and local governments has also changed in important ways. The proportion of grants to places, such as grants for capital investment, has shrunk, and the proportion of grants to individuals has increased markedly. The most important grant to individuals is Medicaid, which has become the single largest federal grant to state and local governments. The federal government affects state and local governments in many other ways. First, indirect forms of federal aid to state and local governments will be discussed.

The federal government provides indirect aid to state and local governments through two provisions of the federal tax code. Individuals can deduct individual income, sales, real estate, and personal property taxes if they itemize deductions on their federal income tax returns. This provision of the federal tax code may make it easier for state and local governments to raise taxes and increase spending.

A second form of indirect federal aid to state and local governments is the exemption from federal taxation of interest on state and local debt, which allows state and local governments to issue debt at lower interest rates than they would otherwise be able to. Table 4 compares the cost of federal grants-in-aid to these two indirect forms of aid. Although federal grants to state and local governments account for over four-fifths of the total cost of federal aid to state and local governments, the cost to the federal government of indirect aid through the tax code is also significant.

The passage of the Tax Cuts and Jobs Act in December , the first major overhaul of the federal tax code since , is likely to significantly reduce the benefits of federal deductibility of state and local taxes and may also have a major impact on the municipal bond market and thus on the exclusion of interest on debt. The federal government affects state and local governments in four other important ways. State personal and corporate income taxes are often linked to their federal counterparts.

For example, some states that impose personal income taxes link their taxes to federal adjusted gross income AGI.

Increases in federal AGI, as with the passage of the Tax Cuts and Jobs Act, will tend to increase state income tax revenues; decreases in federal AGI will tend to decrease state income tax revenues. The federal government also imposes costs on state and local governments through regulatory requirements called mandates.

One example is a direct federal order to implement a particular federal standard, such as the requirement that all public transportation systems be fully accessible to handicapped individuals. Problems with measuring the financial burden of federal mandates are considerable.