The Death of Fiscal Federalism

It’s been a long time since economic policy was forged in the states.

Last May the Obama administration forced South Carolina not just to take its share of federal stimulus funds, but to spend the money on new programs rather than paying down the state’s debt. I was horrified. Obama, I felt, had killed fiscal federalism. Then I realized that fiscal federalism has been dead for a long time. 

Fiscal federalism is the idea that states should set their own economic policies rather than following directives from Washington. Libertarians have a particular attachment to the concept. If states can differentiate themselves on the basis of taxes, spending, and regulation, that gives Americans more leeway in deciding the rules under which we live. If we’re dissatisfied with the policies of the state we live in, we can register our discontent by voting with our feet and moving to another jurisdiction. This competition for residents helps keep lawmakers in check, giving them an incentive to keep taxes and other intrusions modest.

For decades, alas, fiscal power has become increasingly centralized, making a joke of federalism. Washington has taken over more and more state functions, largely through grants to state and local governments, also called grants-in-aid. Figure 1 shows federal grant spending in constant dollars from 1960 to 2013. As you can see, total grant outlays increased from $285 billion in fiscal year 2000 to a whopping $493 billion in fiscal year 2010—a 73 percent increase. Grants also account for a bigger share of federal spending: 18 percent in 2009, compared to 7.6 percent in 1960. 

The same pattern is evident when you look at the total number of federal grant programs (Figure 2). According to data computed by the Cato Institute’s Chris Edwards, in 1980 there were 434 federal grant programs for state and local governments. In 2006 there were 814.

Meanwhile, Washington’s tax bite has grown so big that differences in state tax rates don’t mean as much as they used to. As the table shows, 60 percent of all government revenues in 2008 came from the federal income tax, making it the dominant tax burden in Americans’ lives. In 1930 the figure was 30 percent.

Obviously, other things being equal, it’s less costly to run a business in a state with a low tax rate than in a state with a high tax rate. But that difference becomes less important as the percentage of the total tax bill imposed by the central government grows, especially since you can deduct your state tax bill from your taxable income on your federal return.

What’s more, the overwhelming tax presence of the federal government means state authorities must follow orders from Washington if they want to retrieve some of their constituents’ federal tax dollars. Instead of competing with each other to keep their taxpayers, states compete with each other to get money from the federal government.

This lack of meaningful interstate competition is terrible for taxpayers. The states and the federal government now act as a tax cartel. They are in a position to charge more for their services even when the quality is getting worse.

Choosing where to live was never solely about a state’s fiscal policies, of course. But today state policies are practically irrelevant to the decision. According to a regional household survey conducted by the Metropolitan Philadelphia Indicators Project at Temple University in 2004, just 27 percent of respondents in Philadelphia cited tax concerns as a reason they moved to their current location. Compare this to the 59 percent of survey respondents who said their residential choice was motivated by housing costs, the 47 percent who were motivated by good schools, and the 44 percent who wanted to be closer to family and friends. On the list of reasons for moving, tax concerns ranked ninth.

When respondents were asked whether they had ever considered moving in order to pay lower taxes, 73 percent of Philadelphia residents said no. Within the subsection of respondents living in affluent suburbs, the number climbed to 83 percent. (Interestingly, those who had considered moving because of tax concerns were more likely to move within the next two years than others in the group surveyed.) Similarly, a 2003 study in the Journal of Gerontology found that while tax burdens are the most important fiscal characteristic affecting the location choice of retirement-age individuals, climate, general economic conditions, and housing costs are still much more important. 

In theory, fiscal federalism is a great weapon to hold our state and local governments in line. But today it’s only that, a theory. In practice, it hardly exists. To bring it back, we would need to radically decentralize the government’s power to tax and to spend, abolishing the national income tax altogether and ending federal grants to state and local governments. Under those circumstances, with the feds expelled from our state and local lives, lawmakers would have to cajole us and treat us like high-maintenance mistresses for fear of losing us to the state next door. 

Contributing Editor Veronique de Rugy (vderugy@gmu.edu) is a senior research fellow at the Mercatus Center at George Mason University.

Editor's Note: We invite comments and request that they be civil and on-topic. We do not moderate or assume any responsibility for comments, which are owned by the readers who post them. Comments do not represent the views of Reason.com or Reason Foundation. We reserve the right to delete any comment for any reason at any time. Report abuses.

  • josey||

    How is a state supposed to 'forge economic policy' when the feds claim and enforce imaginary rights to:

    1. monopolize the currency
    2. directly tax the citizenry

    As a state, you simply can't beat that hand. The best you can do is to play ball and try to get as much of your constituent's money back as you can. But of course you can't do that either -- you don't want your state to be cast as a welfare case, do you?

  • ||

    Don't forget their use of that tax revenue to blackmail the states into doing things the federal government probably couldn't legally do directly.

  • Chad||

    You have it entirely backwards. We are moving towards world government, and for a darned good reason: to prevent races to the bottom and beggar-thy-neighbor gamesmanship.

    I don't understand why libertarians refuse to see that states "win" economically by offering businesses the biggest subsidies....and that nation-states aren't any different.

  • Tomcat1066||

    We don't see it because...well....it's bullshit maybe?

  • jcr||

    The more I read Chad's comments, the more I start to think that he doesn't actually believe any of this shit, he is just trying to infuriate us all for his own amusement.

  • ||

    Chad thinks a race to the bottom the smallest, least intrusive state, is a bad thing.

    I'm all for it, myself. One reason I live in Texas, in fact.

  • Chad||

    I prefer my states to "intrude" upon pollution, fraud, and abuse, while preventing people from falling into traps set by game theory and their own irrationality. Of course, none of those exist appreciably in libertopia, right?

  • Tomcat1066||

    What you consider "irrationality" may be someone's investment that they believe is worth the risk. Where do you get off saying otherwise?

  • Chad||

    The mountain of studies that have shown that people are demonstratably irrational on a daily basis, perhaps? Hell, there is a whole sub-field of economics that is devoted to studying how people actually behave, which only vaguely resembles the behavior of Homo Economicus of Libertopia.

  • Damsel in Distress||

    Oh *thank you* Chad, for saving me from my little ole self!!! What evah would I do without your kindly intervention? Why I'm not even sure how I make it to work every day without you there Chad, you selfless thing you!

  • Chad||

    What would you do? Probably be poorer, sicker, and less happy.

    You can thank me some other time.

  • Tomcat1066||

    Homo Economicus? Oh boy you are so fucking funny.

    The problem is, which you don't seem to grasp with your statist mind, is that it's not your place to determine what is "irrational" to the point of preventing someone's own actions.

    Or, will you concede that if a study determined it was irrational to not own a firearm, that you would support legislation requiring everyone to own a gun?

  • Chad||

    And it is not "your place" to organize society in such a way that most people are far less happy than they could be in different situations.

  • Tomcat1066||

    And I'm not organizing shit. I just want people to get out of MY way with their organizing bullshit.

  • generic Brand||

    How can we know people would be far less happy when we've never experienced a non-intrusive government in our lifetimes?

    We are endowed by our Creator the pursuit of happiness, but it never says we are entitled to happiness. And the best way to pursue our own happiness is to have the least amount of restrictions on it. Money earned is far sweeter than money received.

    But I guess a daddy's boy like yourself wouldn't understand that concept.

  • josey||

    If people are irrational, why ought they be allowed to rule over other people?

  • Chad||

    Because not all people are equally irrational.

  • Tomcat1066||

    I suppose you are one the less irrational types?

  • josey||

    And how do you propose to determine who is qualified to rule?

  • Jimmy 'Crack' Corn||

    He is going to ask the NY Times, and then swear by their answer.

  • Mr. Chartreuse Napoleon||

    Yes some animals are more equal than others

  • Teve Torbes||

    People who understand cause and effect are rational. When the government takes away all the penalties for failure, people become less rational and make poorer decisions. The nanny state punishes everyone. Those of greater ability are forced to support those of lesser ability. The latter descend further into dependence and are unable to provide for themselves when the state fails them.

    I'm surprised you didn't squirm when answering the question the way it was stated. Most statists would attempt to hide the fact that they love the phrase "to rule". You love the idea of ruling over the ignorant rabble. You crave adoration from the thankful masses for the scraps you throw them. The idea that some could make their way through life without any helping hand from the benevolent, all-knowing government disgusts you. Those people must be taxed until they have no more than anyone else. There's your real race to the bottom.

  • Chad||

    People who understand cause and effect are rational. When the government takes away all the penalties for failure, people become less rational and make poorer decisions.

    Did it ever occur to you that there are times where this effect is non-existent or even runs in reverse, or that there are many times where this effect is technically real but trivial in extent?

    Probably not, because you clearly belong to the ignorant rabble.

  • josey||

    Aren't you going to answer my question, Raskolnikov?

  • Teve Torbes||

    People such as yourself try to manufacture nuance where none exists to give yourself the appearance of worth. Everyone here can appreciate nuance when it actually exists. We can also see empty words for what they are.

    You favor big government because it provides many bureaucracies for which you can "work". This allows you to feel important in a world where you would otherwise be flipping burgers or mopping floors and cursing yourself for majoring in English Lit with a minor in Women's Studies instead of Engineering or Business. Not to disparage those subjects in particular, but perhaps they only warranted a few credit hours over the course of your undergraduate career rather than being the central focus.

  • josey||

    *crickets*

  • qwerty||

    Yes, because we all know that governments are totally rational all the time. Letting people make decisions for themselves is far worse than forcing them to do want the state wants.

  • Chad||

    I never said that they were, now did they. They just happen to be less irrational than individuals in some cases. I know this really bothers you, but you just have to deal with the facts.

  • ||

    Government is run by people.
    People are irrational.
    Therefore, government is irrational.

    If my neighbor is irrational I can move. If my boss is irrational I can quit. If my government is irrational they take can me away from my children for no reason.

  • Drax the Destroyer||

    You keep referring to Libertopia, but what about it's antithesis, the "utopia" you must value. The place where every man who has an extra dollar he doesn't "need" must give it someone else for nothing, thus making the value of that dollar nothing as well. The place where fraud still occurs because all it takes is the right amount of dough, BJs, and/or Tawainese Trannies supplied to the intellectual elite in order for people garner favors over their fellow man. As a result, the place where those with these favors can abuse their enemies, employees, and customers. The place where people fall into complacency because there is no reason to advance. The place where people "rationally" look to their masters for every decision they would ever need to make, losing to the capacity to value--or even have--their own decisions. The place that doesn't "pollute" because riding around in horse-driven buggies with noxious congealing shit overflowing in the streets is so much better for mankind.

    Holy Crap... I think I just described Cleaveland... Or downtown Baltimore.

  • jk||

    I believe Chad's utopia, the utopia of any statist, is a world free from choice, free from responsibility, and free from consequence. All it takes is total submission to the State.
    With laws governing every aspect of life, there are no choices. The are already made for you by those "more rational" people in government. As long as you follow the rules set forth for you you are not responsible for your actions. How could you be? All choices were made for you. Therefor there are no consequences for your actions, because you are not responsible.
    Supposedly this will free people from the mundane activities of normal existence, and allow people to pursue activities higher on the pyramid of needs.

    That is what a statist calls freedom.

  • Teve Torbes||

    Bingo

  • jk||

    How do you get a sweet lil ol lady to drop the F-bomb?

    Get another sweet lil ol lady to say "Bingo!"

  • ||

    +1

  • Jeff Perren||

    Now I understand where Chad is coming from. He has no original thoughts, so he just re-writes Hobbes.

    Fair enough. If you can't think for yourself, and still want to say something, you have to get your material somewhere.

    Well done, Chad.

  • ||

    So it will make a difference if I pay 38% of my income to Austin instead of 38% to Washington? Not too much. So long as we are the "poor ignorant people" and "don't know what's good for us", the elite idiots will continue to uneducate us, tax us and regulate us into submission.

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  • LifeStrategies||

    Seems like the Founding Fathers got the Constitution about right. Listing the enumerated powers was a great idea. Switzerland copied and improved the US Constitution, and there the Feds are kept in place by an effective and empowered electorate while the different states (cantons) have the right to govern themselves on local issues. For more, see http://www.LifeStrategies.net/switzerland

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