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 ([e-mail]) is a senior research fellow at the Mercatus Center at George Mason University.