Fiscal Federalism

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Chris Edwards

June 2013

Introduction
Brief History of Federal Aid
The Federal Aid System Today
Eight Reasons to Cut Aid
Conclusions

 

Introduction

The federal government has developed a hugely complex financial relationship with state governments through the grants-in-aid system. The system has grown steadily for more than a century as the federal government has become involved in an increasing array of state and local activities. Today there are more than 1,100 different federal aid programs for the states, with each program having its own rules and regulations. The system is a complicated mess, and it is getting worse all the time. 

It wasn’t supposed to be this way. Under the U.S. Constitution, the federal government was assigned specific, limited powers and most government functions were left to the states. To ensure that people understood the limits on federal power, the nation’s founders added the Constitution’s Tenth Amendment: “The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.”

The Tenth Amendment embodies federalism, the idea that federal and state governments have separate areas of activity and that federal responsibilities were “few and defined,” as James Madison noted. Historically, federalism acted as a safeguard of American freedoms. President Ronald Reagan noted in a 1987 executive order, “Federalism is rooted in the knowledge that our political liberties are best assured by limiting the size and scope of the national government.”1

Unfortunately, policymakers and courts have mainly discarded federalism in recent decades. Congress has undertaken many activities that were traditionally reserved to the states and the private sector. Grants-in-aid are a key mechanism that the federal government has used to extend its power into state and local affairs. Grant programs are subsidies that come part and parcel with federal regulations designed to micromanage state and local activities.

The federal government will spend $561 billion on aid to the states in 2013, making aid the third largest item in the federal budget after Social Security and national defense.2 Some of the major federal aid programs are in the areas of education, health care, housing, and transportation.

There are few, if any, advantages of federalizing state and local activities through grant programs, but many disadvantages. The aid system encourages excessive spending and bureaucratic waste, creates a lack of political accountability, and stifles policy diversity and innovation in the states. With the ongoing flood of red ink in Washington, now would be a good time to begin cutting the vastly overgrown grants-in-aid system.
 

Brief History of Federal Aid

Prior to the Civil War, proposals to subsidize state and local activities were occasionally introduced in Congress, but they were routinely voted down or vetoed by presidents for being unconstitutional. In 1817, for example, President James Madison vetoed a bill that would have provided federal aid to construct roads and canals.3 In 1830, President Andrew Jackson vetoed a bill to provide aid for a road project in Kentucky arguing that it was of “purely local character” and that funding would be a “subversion of the federal system.”4

The resistance to federal funding of state activities started to weaken toward the end of the 19th century. The Morrill Act of 1862 provided grants of federal land to the states for the establishment of colleges that focused on agriculture, mechanical studies, and the military. This was the first grant program with “strings attached.” It included detailed rules for recipients to follow and required them to submit regular reports to the federal government.

Federal aid activity increased substantially in the early 20th century. When the income tax was introduced in 1913, it provided the means for policymakers to finance a range of new federal aid programs.

From the beginning, many aid programs required states to match federal funds on a dollar for dollar basis. Unfortunately, matching requirements have induced excessive state spending and continuous program expansion. Federal aid has also prompted the growth in state bureaucracies, partly because aid programs have often required that states set up new agencies to oversee spending in the prescribed activities.

There was initial resistance to the expansion of federal aid, but it was politically difficult for states to opt-out of new aid programs. That’s because if they did opt-out, their residents would still have to pay federal taxes to support federal aid spending in other states.

Also, various sleights-of-hand were used to get around constitutional concerns about rising federal power. For example, a 1916 law that created a new federal program for road subsidies was premised on the constitutional power to fund “post roads” (roads used for mail delivery), which Congress defined very broadly.5 Another example was 1911 legislation to fund state forest fire prevention. The aid was to pay for forest activities near navigable rivers, which thus could be said to be related to interstate commerce.6

The number of grants-in-aid programs rose from 15 in 1930 to 132 by 1960. The largest expansion of federal granting during this period was the 1956 law authorizing the building of the interstate highway system.

However, it was during the 1960s that federal aid really exploded. Under President Lyndon Johnson, aid programs were added for housing, urban renewal, education, health care, and many other activities. The number of aid programs quadrupled from 132 in 1960 to 530 by 1970.7

In the 1960s, policymakers were optimistic that federal experts could solve local problems—such as urban decay—with aid programs. But the optimism began to diminish even by the early 1970s. President Richard Nixon argued that federal aid was a “terrible tangle” of overlap and inefficiency.8 In his 1971 State of the Union address, he lambasted “the idea that a bureaucratic elite in Washington knows best what is best for people everywhere,” and said that he wanted to “reverse the flow of power and resources from the states and communities to Washington.”9 For his part, President Jimmy Carter proposed a “concentrated attack on red tape and confusion in the federal grant-in-aid system.”10 Unfortunately, Nixon and Carter made little progress on reforms.

Ronald Reagan had more success at sorting out the “confused mess” of federal grants, as he called it.11 In a 1981 budget law, dozens of grant programs were eliminated, and many others were consolidated into broader block grants. The number of grant programs fell during the early 1980s.

Reagan’s “new federalism” attempted to re-sort federal and state activities so that each level of government would have responsibility for financing its own programs. But Reagan’s progress at trimming the federal aid empire was reversed after he left office, and there have been no major efforts to reform or cut the federal aid system since the mid-1990s.

The aid system’s many failings have become more acute as hundreds of more programs have been added in recent years. According to my analysis, the number of aid programs soared from 653 in 2000 to 1,122 by 2010.12 President Obama’s health care law of 2010 added a range of new aid programs, and it also involved a huge expansion in Medicaid, which is the largest federal aid program.
 

The Federal Aid System Today

Today, the number of federal aid programs for the states is more than triple the number just 25 years ago. Federal aid spending is expected to be $561 billion in fiscal 2013, of which $286 billion are health grants and $275 billion are non-health grants.13 Aid programs range from the giant $267 billion Medicaid to hundreds of more obscure programs, such as a $15 million grant for “Nursing Workforce Diversity,” a $116 million grant for “Boating Safety Financial Assistance,” and a $125 million grant for “Healthy Marriages.”

Federal aid can be distributed in the form of project grants or formula grants. Under project grants, federal agencies distribute funding to particular state and local agencies after a detailed review of specific proposals. Project grants can also be “earmarked” or directed to favored activities by members of Congress. Project grants generally require grantees to submit proposals, detailed work plans, regular reports, and other paperwork regarding their use of federal dollars.

While most aid programs are project grants, most aid spending is on formula grants. That is because many of the largest aid programs, including Medicaid, are formula grants. Under formula grants, legislation spells out how much funding each state receives based on factors such as state income and population. The states are often required to match some portion of the federal government’s aid with their own funding.

Aid programs can also be categorized as either categorical grants or block grants. The bulk of grants are categorical, which generally target a narrow range of eligible activities and include detailed regulations that states must follow. By contrast, block grants fund a broader range of activities and generally give states more flexibility on the activities funded.

Budget experts have long proposed that the plethora of categorical grants be consolidated into fewer and simpler block grants. However, there are strong political incentives against such reforms. One factor is that members of Congress can better target their favored special interests using categorical grants. Categorical grants are also in sync with the fragmented committee structure in Congress. That is, each of the dozens of committees and subcommittees in Congress want their own realm of grant programs to preside over. If grants were consolidated, members would lose some of their power to direct and control federal hand-outs.

One question that arises with regard to the federal aid system is how it redistributes resources between the 50 states. The system involves the raising of hundreds of billions of dollars a year in taxes from individuals and businesses across the nation, and then running the money through the Washington bureaucracy and dishing it back to government agencies in the states.14 There is no overall plan to the system; instead, it has grown in an ad hoc manner over many decades.

The aid system is mainly financed by the general fund of the federal budget, of which the largest revenue source is the personal income tax.15 The income tax is highly graduated or “progressive.” As a result, states with large concentrations of higher-income residents pay a large bulk of the nation’s income taxes, and thus finance a large share of the grants-in-aid system. As an illustration, the top two states in terms of overall per-capita federal taxes—Connecticut and New Jersey—pay more than twice as much in per-capita taxes as the lowest two states, West Virginia and Mississippi.16

Looking at the spending side, aid received by the states varies widely. In 2010, for example, average grants-in-aid spending was $2,187 per capita. The state receiving the highest per-capita amount was Alaska at $4,879, while the state receiving the lowest amount was Florida at $1,492.17

The reasons for these variations in aid spending are complex. Project grants are generally distributed on a discretionary basis. But most federal aid is distributed by formulas, which are based on such factors as state populations, income levels, and poverty levels. Medicaid funding, for example, is distributed based on each states’ average personal income compared to the U.S. average. Thus, poorer states generally receive a higher federal match, although there are many complexities to the Medicaid allocation system.18

With open-ended matching grants, the expansiveness of each state’s spending affects the amount of funding drawn from Washington. Medicaid, for example, allows states substantial flexibility in structuring benefits, and thus those states that have more generous benefits will gain more federal matching dollars. New York has an expansive benefit structure, and it receives 12 percent of all federal Medicaid dollars even though the state has just 6 percent of the U.S. population.19

Some grant programs have complex formulas to distribute funding, which sets up political struggles to tweak the allocations. Consider the Community Development Block Grant program, which funds local development projects. One item in the formula that distributes funding to the states is “housing built before 1940.” How did this obscure provision get into the CDBG formula? A lobby group convinced some members of Congress to insert it into legislation in order to tilt aid toward older cities.20

Politics often stands in the way of allocating grant funds in a way that even aid supporters would think is rational. After 9/11, for example, the federal government created numerous homeland security aid programs to help those areas of the country at higher risks of terrorism. But members of Congress from lower-risk and more rural states have battled to distribute these grants based on metrics unrelated to risk.21

In sum, there is no overall strategy that guides the grants-in-aid system. Instead, it has been jerry-built over the decades as politicians have responded to special-interest pressures and tried to fix state and local problems with federal rules and subsidies. Liberal policymakers have supported the federalizing of state activities because the federal tax system is more graduated or “progressive” than state tax systems. And conservative policymakers have usually gone along with aid expansions because they can garner the political benefits of steering funding to their congressional districts.

While the growth in federal aid can be explained by politics, the next section explains that there has never been a good rationale for aid from the perspective of efficient and responsible governance.
 

Eight Reasons to Cut Aid

The theory behind grants-in-aid is that the federal government can create subsidy programs in the national interest to efficiently solve local problems. The belief is that policymakers can dispassionately allocate large sums of money across hundreds of activities based on a rational plan designed in Washington. 

The federal aid system does not work that way in practice. Most federal politicians are not inclined to pursue broad, national goals, but are consumed by the competitive scramble to secure subsidies for their states. At the same time, federal aid stimulates overspending by state governments and creates a web of top-down rules that destroy state innovation. At all levels of the aid system, the focus is on maximizing the money spent and regulatory compliance, not on delivering quality services.

The following are eight reasons why the federal aid system doesn’t make any economic or practical sense and ought to be downsized or eliminated.

1. No magical source of federal funds. Aid supporters bemoan the “lack of resources” at the state level and believe that Uncle Sam has endlessly deep pockets to help out. But every dollar of federal aid sent to the states is ultimately taken from federal taxpayers who live in the 50 states. It’s true that the federal government has a greater ability to run deficits than state governments, but that’s an argument against the aid system not in favor of it. By moving the funding of state activities up to the federal level, the aid system has tilted American government toward unsustainable deficit financing.

2. Grants spur wasteful spending. The basic incentive structure of aid programs encourages overspending by federal and state policymakers. One reason is that policymakers at both levels can claim credit for spending on a program, while relying on the other level of government to collect part of the tax bill.

Another cause of overspending is that federal policymakers create program structures, such as matching, that prompt the states to increase spending. A typical match is 50 percent, which means that for every $2 million a state expands a program, the federal government chips in $1 million. Matching reduces the “price” of states’ added spending, thus prompting them to expand programs. Most federal aid is for programs that have matching requirements, with Medicaid being the largest such program.

One way to reduce spending incentives is to convert open-ended matching grants to block grants. Block grants provide a fixed sum to states and give them flexibility on program design. The best example of such a reform was the 1996 welfare overhaul, which turned Aid to Families with Dependent Children (an open-ended matching grant) into Temporary Assistance for Needy Families (a lump-sum block grant). Similar block grant reforms should be pursued for Medicaid and other programs. Converting programs to block grants would reduce incentives for states to overspend, and it would make it easier for Congress to cut federal spending in the future.

3. Aid allocation doesn’t match any consistent idea of need. Supporters of federal grants assume that funding can be optimally distributed to those activities and states with the greatest needs. But even if such redistribution was a good idea, the aid system has never worked that way in practice. A 1940 article in Congressional Quarterly lamented: “The grants-in-aid system in the United States has developed in a haphazard fashion. Particular services have been singled out for subsidy at the behest of pressure groups, and little attention has been given to national and state interests as a whole.”22 And a 1981 report by the Advisory Commission on Intergovernmental Relations concluded that “federal grant-in-aid programs have never reflected any consistent or coherent interpretation of national needs.”23 It’s the same situation today. With highway aid, for example, some states with greater needs due to growing populations—such as Texas—consistently get the short end of the stick on funding.24

Even if funds were allocated to the states based on need, state-level decisions can nullify federal efforts. For example, the largest education grant program, Title I, is supposed to target aid to the poorest school districts. But evidence indicates that state and local governments use Title I funds to displace their own funding of poor schools, thus making poor schools no further ahead than without federal aid.25

4. Grants reduce state policy diversity. Federal grants reduce state diversity and innovation because they come with one-size-fits-all mandates. A good example was the 55-mile-per-hour national speed limit, which was enforced between 1974 and 1995 by federal threats of withdrawing highway grant money. It never made sense that the same speed should be imposed in uncongested rural states and congested urban states, and Congress finally listened to motorists and repealed the law.

Another example of top-down federal rules is the No Child Left Behind education law of 2002. To receive NCLB grant funding, the law required states to meet federal mandates, such as ensuring that all teachers were “highly qualified,” that Spanish-language versions of tests be administered, and that certain children be tutored after school. Many states passed resolutions attacking NCLB for undermining states’ rights.

The Davis-Bacon labor rules are another example of harmful regulations tied to federal aid. State public works projects that receive federal aid must pay workers “prevailing wages.” Since that generally interpreted to mean higher union-level wages, Davis-Bacon rules increase construction costs on government investments, such as highway projects.

5. Grant regulations breed bureaucracy. Federal aid is not a costless injection of funding to the states. Federal taxpayers pay the direct costs of the grants, but taxpayers at all levels of government are burdened by the costly bureaucracy needed to support the system. The aid system engulfs government workers with unproductive activities such as proposal writing, program reporting, regulatory compliance, auditing, and litigation. 

Many of the 16 million people employed by state and local governments must deal with complex federal regulations related to hundreds of aid programs. There are specific rules for each program, which may be hundreds or even thousands of pages in length. There are “crosscutting requirements,” which are provisions that apply across aid programs, such as labor market rules. And there are “crossover sanctions,” which are the penalties imposed on the states if they don’t meet federal requirements.

Each of the more than 1,100 aid programs have different rules, and the activities funded by the programs often overlap, which causes more confusion. For example, state and local officials deal with 16 different federal programs that fund first responders, such as firefighters.26 That tangle of programs not only creates a lot of paperwork, it may also lead to more fragmented planning of disaster response.

6. Grants cause policymaking overload. One consequence of the large aid system is that the time spent by federal politicians on state and local issues takes away from their focus on truly national issues. In the years after 9/11, for example, investigations revealed that most members of the House and Senate intelligence committees did not bother, or did not have time, to read crucial intelligence reports.27 Many of these members were probably spending their time trying to steer budget monies toward local activities in their home states.

The federal involvement in hundreds of nonfederal policy areas overloads Washington’s policy agenda. President Calvin Coolidge was right in 1925 when he argued that aid to the states should be cut because it was “encumbering the national government beyond its wisdom to comprehend, or its ability to administer” its proper roles.28 

7. Grants make government responsibilities unclear. The three layers of government in the United States no longer resemble the tidy layer cake that existed in the 19th century. Instead, they are like a jumbled marble cake with responsibilities fragmented across multiple layers. Federal aid has made it difficult for citizens to figure out which level of government is responsible for particular policy outcomes. All three levels of government play big roles in such areas as transportation and education, thus making accountability difficult. To make matters worse, politicians have become skilled at pointing fingers of blame at other levels of government, as was evident in the aftermath of Hurricane Katrina in 2005. When every government is responsible for an activity, no government is responsible.

8. Common problems are not necessarily national priorities. Policymakers often argue that various state, local, and private activities require federal intervention because they are “national priorities.” But as President Reagan noted in a 1987 executive order: “It is important to recognize the distinction between problems of national scope (which may justify federal action) and problems that are merely common to the states (which will not justify federal action because individual states, acting individually or together, can effectively deal with them).”29

Consider education. It is a priority of many people, but that does not mean that the federal government has to get involved. State and local governments should be free to innovate in education and share best practices with each other, but there is no reason for top-down controls or funding from Washington. Or consider federal aid for homeland security, which became popular after 9/11. Much of the federal funding in that area goes for items that could be funded locally, such as bulletproof vests for police officers.

There is no reason for federalizing spending on local activities such as police and education—it just creates added bureaucracy and a tug of war over funding allocations. By contrast, when funding and spending decisions are made together at the state or local levels, policy tradeoffs will better reflect the preferences of citizens within a jurisdiction.
 

Conclusions

The federal aid system is a roundabout way to fund state and local activities that serves no important economic or practical purpose. The system has many widely-recognized failings, but a web of special interest groups block reforms. Those groups include the hundreds of trade associations that represent the recipients of federal aid and the millions of state and local employees that depend on federal aid to pay their salaries.

The aid system thrives not because it creates good governance, but because it maximizes benefits to politicians. The system allows politicians at each level of government to take credit for spending, while blaming other levels of government for program failures and high tax burdens. The federal aid system has been called a “triumph of expenditure without responsibility.”

The aid system should be dramatically scaled back or phased-out altogether. With today’s huge federal budget deficits, now is a good time to start cutting federal spending on state and local activities. By federalizing so many state and local activities in recent decades, we are asking Washington policymakers to do the impossible—to efficiently plan for the competing needs of a vast and diverse country of 315 million people.


1 Ronald Reagan, Executive Order 12612, October 26, 1987, www.reagan.utexas.edu/archives/speeches/1987/102687d.htm.

2Budget of the U.S. Government, FY2014, Analytical Perspectives (Washington: Government Printing Office, 2013), p. 301.

3 James Madison, veto message for the Bonus Bill, March 13, 1817. Available at www.constitution.org/jm/18170303_veto.htm.

4 Andrew Jackson, veto message for the Maysville Road Bill, May 27, 1830. Available at www.gutenberg.org/files/10858/10858-h/10858-h.htm.

5 Austin F. MacDonald, Federal Aid: A Study of the American Subsidy System (New York: Thomas Y. Crowell, 1928), p. 90. See also Richard F. Weingroff, “For the Common Good: The 85th Anniversary of a Historic Partnership,” Public Roads, vol. 64, no. 5, Federal Highway Administration, March/April 2001.

6 Austin F. MacDonald, Federal Aid: A Study of the American Subsidy System (New York: Thomas Y. Crowell, 1928), p. 30.

7 Chris Edwards, “Federal Aid to the States: Historical Cause of Government Growth and Bureaucracy,” Cato Institute Policy Analysis no. 593, May 22, 2007.

8 Quoted in Ben Canada, “Federal Grants to State and Local Governments: A Brief History,” Congressional Research Service, RL-30705, February 19, 2003, p. 9.

9 Richard Nixon, “Annual Message to the Congress on the State of the Union,” January 22, 1971. Available at www.nixonlibrary.org.

10 Advisory Commission on Intergovernmental Relations, “The Intergovernmental Grant System: An Assessment and Proposed Policies,” January 1978, p. 24.

11Budget of the U.S. Government, FY1983, “Budget Message of the President,” (Washington: Government Printing Office, February 1982), p. M22.

12 Chris Edwards, “Federal Aid-to-State Programs Top 1,100,” Cato Institute Tax and Budget Bulletin no. 63, February 2011.

13Budget of the U.S. Government, FY2014, Analytical Perspectives (Washington: Government Printing Office, 2013), p. 301.

14 The system could also be said to funded by federal borrowing, in which case the cost to taxpayers is deferred.

15 The main exception are federal highway grants, which are mainly funded by the federal gasoline tax.

16 Curtis Dubay, “Federal Tax Burdens and Expenditures by State,” Tax Foundation, March 2006, Table 4.

17 U.S. Bureau of the Census, “Consolidated Federal Funds Report for Fiscal Year 2010,” September 2011, Table 10.

18 For background, see Kaiser Family Foundation, “Medicaid Financing: An Overview of the Federal Medicaid Matching Rate,” September 2012.

19Budget of the U.S. Government, Fiscal Year 2014, Analytical Perspectives (Washington: Government Printing Office, 2013), p. 318.

20 Rochelle L. Standfield, “Playing Computer Politics with Local Aid Formulas,” in Laurence J. O’Toole, ed., American Intergovernmental Relations (Washington: Congressional Quarterly, 1985), p. 175.

21 Chris Strohm, “Senate Fight Looms Over Revising Security Grant Formula,” Congress Daily, February 16, 2007, p. 9. See also Veronique de Rugy, “What Does Homeland Security Spending Buy,” American Enterprise Institute, October 29, 2004.

22 B. Putney, “Federal-State Relations Under Grants-In-Aid,” Congressional Quarterly, July 30, 1940.

23 Advisory Commission on Intergovernmental Relations, “The Federal Role in the Federal System: The Dynamics of Growth,” vol. X, June 1981, p. 94.

24 Ronald Utt, “Turn Back Transportation to the States,” Heritage Foundation, February 6, 2012, p. 2.

25 Nora Gordon, “Do Federal Grants Boost School Spending? Evidence from Title I,” Working Paper, Department of Economics, University of California, San Diego, September 2002.

26 Government Accountability Office, “Federal Assistance: Grant System Continues to Be Highly Fragmented,” GAO-03-718T, April 29, 2003, pp. 13, 14.

27 Dana Priest, “Congressional Oversight of Intelligence Criticized,” Washington Post, April 27, 2004, p. A1. And see Victoria Toensing, “Oversee? More Like Overlook,” op-ed, Washington Post, June 13, 2004.

28 Quoted in Charles Warren, Congress as Santa Claus or National Donations and the General Welfare Clause of the Constitution (New York: Arno Press, 1978), p. 103. (Originally published by the Michie Company, Charlottesville, Virginia, 1932).

29 Ronald Reagan, Executive Order 12612, October 26, 1987, www.reagan.utexas.edu/archives/speeches/1987/102687d.htm.