What You Don’t Know About Fiscal Federalism
CAN HURT YOU
by joshua mccabe
joshua mccabe is a sociologist at Endicott College in Beverly, Mass., and a senior fellow at the Niskanen Center in Washington. This article is adapted from a more technical Niskanen Center report.
Illustrated by robert neubecker
Published May 4, 2020
When 20,000 West Virginia public school teachers walked out on strike in February 2018, the reason was clear to education specialists. According to the National Education Association, the average salary for West Virginia teachers was about $46,000 in 2016. This was about 77 percent of the national average, making them among the lowest paid in the country. The state’s Republican governor agreed that its teachers were underpaid, but worried about the state’s ability to fund the raises the teachers were demanding. Despite high spending relative to its fiscal means and supplements from federal education grants, West Virginia still found itself among the bottom 10 states in terms of spending per pupil.
Maine made headlines in January 2019 when Janet Mills, the newly elected governor, signed an executive order expanding Medicaid under Obamacare guidelines. The expansion had been approved in a 2017 ballot initiative, but subsequently held up by Mills’s predecessor, Paul LePage, who claimed it would “put the state in red ink.”
Maine’s delay stood in contrast to the rest of New England, where all other states had expanded their Medicaid programs as soon as permitted by Obamacare. It has been popular to chalk up Maine’s delay to the personal recalcitrance of LePage. But a close look suggests that the long-term budget effects of Medicaid expansion could be substantial. And Maine’s fiscal capacity — more on this later — ranks among the 10 lowest in the country.
In October 2019, The Tennessean reported that Tennessee had amassed $732 million in unused Temporary Assistance for Needy Families federal block grant funding in its reserve fund over the course of the last economic recovery. Critics questioned why Gov. Bill Lee would stash away the country’s largest surplus while 28 percent of the state’s children continued to live below the poverty line. But nobody questioned why a state as poor as Tennessee had received one-third the amount of TANF funding per child as wealthy Connecticut in the first place.
These stories tap into two of the most enduring myths in American political discourse. The first is that states like West Virginia, Maine and Tennessee have shortsightedly pursued “low tax, low service” growth strategies while states like New York, Massachusetts and Connecticut have wisely pursued a “high tax, high service” strategy. The second is that our system of federal grants massively redistributes funding to the former states from the latter. A closer look at the data tells a much more complicated story.
Rich State, Poor State
“Fiscal capacity” refers to a government’s ability to raise revenue to finance public goods and services. As state and local governments rely primarily on income, sales, property and excise taxes for this purpose, their capacity is limited by the total amount of taxable resources available to them. Fiscal capacity varies substantially across states and municipalities, of course, because their taxable resources vary substantially.
Traditionally, public finance specialists have measured fiscal capacity in terms of gross state product (GSP) per capita or state personal income (SPI) per capita. But there are several limitations to these approaches because some of these resources are not taxable in the state in which they are produced or earned. Delaware, for example, scores high on GSP per capita because it is home to a large number of corporate headquarters. However, its actual fiscal capacity is less than one might expect because much of those profits flow to shareholders — and will be taxed — in other states.
Congress recognized these limitations back in 1986 when it asked the Treasury to come up with annual estimates of total taxable resources (TTR) for each state. TTR is superior to alternative measures as a basis for gauging fiscal capacity because it subtracts non-taxable revenue flowing out of the state and adds taxable revenue flowing in. It thus measures only resources that a state can potentially tax to generate revenue.
Whereas state poverty rates make headlines every day, few people are familiar with the extent to which fiscal capacity varies across states. On one hand, Connecticut’s total taxable resources amounted to $86,480 per capita in 2016 (the last year in which data are readily available). The state can raise revenue with relatively little effort. On the other end, Mississippi’s total taxable resources amounted to $41,391 per capita. If Mississippi tried to raise as much revenue per capita as Connecticut, it would need to impose a tax burden more than twice that of Connecticut. Hence, in my view, the best way to measure a state’s fiscal effort is to look at total own-source revenues (which excludes federal grants) as a proportion of TTR.
The scatter plot offers an easy way to see the unintuitive relationship between fiscal capacity and fiscal effort across the 50 states. As the slope of the line suggests, poor states tend to make greater efforts to generate their own revenue than wealthy states. Mississippi, for example, raises less than three-quarters of Connecticut’s per capita revenue. But this doesn’t imply that Mississippians are less willing to pay for public safety, decent infrastructure, good schools and an effective social safety net than residents of Connecticut. Indeed, one might argue the opposite: Mississippi’s fiscal effort (16.7 percent of TTR in 2016) greatly surpassed that of Connecticut (11 percent of TTR).
Rethinking American Federalism
The problem of disparities in fiscal capacity across state and local governments is not new, nor is it uniquely American. We see similar issues across the states of the former East and West Germany, between Canada’s western and maritime provinces, and among Australia’s southwestern and northeastern states. The key difference is that, unlike the United States, these countries have designed systems to systematically improve the relative fiscal capacity of poor states.
Washington will dole out some $750 billion in grants to state and local governments this year, much of it with the avowed goal of reducing disparities between rich and poor states. But according to Jonathan Rodden, a political scientist at Stanford, the effort falls far short. Contrary to the conventional wisdom, Rodden concludes that “no matter how one tortures the data, intergovernmental grants in … the United States are simply not progressive.” To understand why, we need to delve into the features of intergovernmental grants that influence their progressivity.
Designing Intergovernmental Grants
Policymakers have four levers at their disposal when crafting intergovernmental grants. First, the federal government must choose whether to finance the transfer as a matching grant or block grant. With a matching grant, the funding a state receives is conditional on the amount it spends from its own-source revenues. For example, a 50-50 formula would result in the federal government contributing a dollar for every dollar a state spends on a given program. With a block grant, the federal government contributes some fixed amount regardless of state’s own spending decisions.
In general, matching grants based on simple formulas tend to exacerbate regional disparities because states with greater fiscal capacity can and do raise more with the same effort, and therefore receive higher levels of per capita funding from the federal government. Imagine, for example, that Connecticut and Mississippi both dedicated 2 percent of their total taxable resources to a program eligible for a generous 90/10 federal matching grant — as is the case with the recent Medicaid expansion. Mississippi would raise about $838 per capita and receive a federal contribution of about $7,548 per capita. Connecticut would raise about $1,730 per capita and receive a federal contribution of and $15,566 per capita. For the same effort, wealthy Connecticut receives twice as much per capita as poor Mississippi and total spending per capita is twice as high in Connecticut. In contrast, a flat per capita block grant would reduce interstate disparities.
Flat per capita block grants moderately reduce disparities, varying the grant based on such factors as persons in poverty per capita or total taxable resources per capita can push the process further.
Second, the federal government must choose whether to allocate grants on a flat or variable basis. For matching grants, this can take several forms. While the flat matching grants described above will exacerbate state disparities, variable matching grants have the potential to reduce them. For example, the federal government can vary the match based on fiscal capacity, say, with states receiving a match somewhere between 25 percent and 75 percent as they move from above-average to below-average fiscal capacity. The extent to which this is effective will depend crucially on the amount of variation with any given grant.
For block grants, variable allocation has the greatest potential to minimize interstate disparities. While the flat per capita block grants described earlier tend to moderately reduce disparities, varying the grant based on such factors as persons in poverty per capita or total taxable resources per capita can push the process much further.
In a pure equalization block grant, such as those provided by the federal governments in Canada and Australia, only states with belowaverage fiscal capacity receive any funding. The most funding per capita goes to those with the least fiscal capacity, and the funding gets progressively smaller until it phases out altogether for states with average fiscal capacity or above.
Policymakers do not necessarily craft variable block grants to reduce disparities, though. The 1996 conversion of the matching grant for Aid to Families with Dependent Children — what used to be called “welfare” — into the Temporary Assistance to Needy Families block grant, for example, resulted in variation based on previous spending levels under the old formula. This carried over and froze existing disparities as part of the new block grant formula. It is important to note that this policy choice — freezing the previous formula — rather than some intrinsic characteristic of block grants is what has led to TANF’s unequitable allocation today.
Third, the federal government must choose the extent to which grants will be conditional in nature. Matching grants, by definition, are conditional on state spending, whereas block grants are unconditional in this respect. All existing federal grants in the United States come with some strings. On one end of the spectrum, categorical grants for specific projects leave states with little discretion over the use of funds. In the middle, the Medicaid matching grant allows state discretion within the program parameters, while the TANF block grant allows more discretion as long as funds are spent with the avowed goal of aiding the poor.
The federal government’s short-lived (1972-86) general revenue sharing program is the only recent example of an unconditional federal grant to states and local governments in which they could spend the fund however they deemed fit. Many states, it’s worth noting, do disburse unconditional block grants to municipalities in the form of general local aid.
Fourth, the federal government must choose whether and how it will adjust grants based on changing circumstances. Adjustment will occur automatically in the case of matching grants as the federal contribution reflects changes in state choices. For block grants, the two most important factors to consider are adjustments for population and for inflation. Without adjustments for population change or inflation — the case with TANF — the per capita real value of the grant shrinks over time and its allocation becomes distorted as state populations grow (or shrink) at different rates.
Theory Versus Reality
We know how to design federal grants to reduce fiscal disparities, but how well do our existing grants for education, health care and social assistance meet this goal? It turns out that the leading education grant program is slightly progressive, Medicaid grants are essentially flat and TANF grants are surprisingly regressive.
Title I, the primary provision in the Elementary and Secondary Education Act responsible for allocating funds, has undergone a number of formula changes since its introduction in 1965. Currently, funds are distributed based on four separate formulas. The basic grant, concentration grant and targeted formulas are each tied to the number of poor students in a school district. While not directly considering fiscal capacity, this is a rough proxy for fiscal capacity on the local level, given existing levels of economic and racial segregation. School districts with a higher proportion of poor students typically lack the property tax base to fund schools at levels comparable to their wealthy neighboring districts.
The education finance incentive grant formula considers a mix of factors, including the proportion of poor students, fiscal effort (spending per pupil as a proportion of state per capita income), spending per pupil and equity across school districts within a state. Some factors, like proportion of poor students, reduce disparities, while others, like spending per pupil, have the effect of increasing them.
Overall, Title I block grants marginally reduce education spending disparities between states with high and low fiscal capacity. This makes education grants much more equitable than Medicaid and TANF grants, but still leaves much room for improvement. New York, which ranks second in terms of fiscal capacity, receives more in Title I funding per pupil ($399) than any other state. Utah, on the other hand, has below-average fiscal capacity, yet receives less in Title I funding per pupil ($106) than any other state.
In some cases by choice and in some by court order, most states have introduced policies to help equalize spending across districts.
One of the major shortcomings of the various Title I grant formulas is that they focus on the characteristics of individual school districts rather than the states in which they operate. This neglects the growing role of states in school finance, which are the top source of funding for education. The large role of states in school finance reflects concerns over intrastate disparities between wealthy and poor school districts. In some cases by choice and in some by court order, most states have introduced policies meant to help equalize spending across districts. Despite these changes, ESEA largely treats districts as if they are still on their own when it comes to financing education.
This creates gross inefficiencies by allocating a large proportion of national funding to poor districts in wealthy states. We can illustrate the issue by taking a hypothetical example of two poor school districts — one in Mississippi and one in Connecticut — with similar proportions of students in poverty. The existing Title I formulas treat the districts as if they are similarly limited in their abilities to finance adequate levels of education. In reality, the poor district in wealthy Connecticut is in a much better fiscal position than the poor district in poor Mississippi after accounting for state funding.
Medicaid’s current formula, the Federal Medical Assistance Percentages, has several features that could potentially reduce interstate disparities. It is a variable matching grant that provides more generous matches to states with below-average fiscal capacity. In addition, the Affordable Care Act (aka Obamacare) gave states the option to further expand Medicaid to “newly eligible” individuals with incomes up to 133 percent of the federal poverty level with a flat federal matching rate of 90 percent (which was even higher in early years of the ACA). That said, however, both the traditional FMAP and ACA formulas have major shortcomings that put poor states at a disadvantage relative to wealthy states.
First, they both take the form of matching grants. Matching grants, especially those with flat rates, tend to reward states with higher fiscal capacity. Under the ACA’s 90 percent matching rate, Mississippi would need to increase the state’s Medicaid spending twice as much in terms of their proportion of the total taxable resources as Connecticut in order to receive the same per capita federal funding. Insofar as the traditional FMAP formula varies based on fiscal capacity, it reduces this inequity. Thus, it much better at reducing interstate disparities despite the fact that the range of matching percentages is much lower than 90 percent.
Second, the progressive nature of the FMAP variable match is blunted by a statutory minimum matching rate of 50 percent for wealthy states. In 2020, there will be 14 states that will receive matching rates higher than they would otherwise under a pure fiscal capacity formula. In some cases, such as Minnesota and Colorado, the difference is minimal. In others, including Connecticut and Massachusetts, the statutory minimum provides a significant windfall to the tune of billions each year. The result is a generally flat distribution of funding that does little to reduce interstate disparities.
The law that created Medicaid in 1965 gave states the option of using the new FMAP formula to determine what was then Aid to Families with Dependent Children (AFDC) funding, which all states eventually adopted. Congress also applied the same statutory minimum (50 percent) and maximum (83 percent) matching rates for AFDC funding. Recall that the FMAP formula reduces disparities in fiscal capacity insofar as it’s based on state per capita income, but exacerbates it insofar as it requires state matching and applies a statutory minimum match to the wealthiest states.
As noted above, the 1996 welfare reforms converted the AFDC matching grant into the TANF block grant. The debate over blockgranting TANF is rife with misperceptions about the effects it had on the program. Many policymakers assume converting matching grants into block grants necessarily drove the kind of retrenchment and misallocation that we have seen with the TANF block grant. This is not the case.
The key difference between a matching grant and a block grant is that the latter is based on some fixed sum other than what state contributed to the program. The problem with the TANF block grant was that it based the allocation on historic AFDC expenditures. This had the effect of freezing the existing FMAP-based inequities into the new law. Because wealthy states have historically been able to spend more on AFDC, they would be rewarded with more generous block grants. Because poor states lacked the fiscal capacity to spend more, they would be penalized under the new law. Today, wealthy Connecticut receives two and a half times as much per child as poor Tennessee.
Although several presidential candidates have released plans to reform education and social assistance funding, there’s no indication they understand or appreciate the importance of interstate fiscal disparities.
In addition to locking in an inequitable distribution of funding, the TANF block grant had two other shortcomings related to the fact that it was created as a lump sum. First, it was set in nominal terms, leaving it open to erosion from inflation. The total amount of the basic block grant was $16.5 billion in 1997. Had it been indexed for inflation, it would be about $26 billion today. Instead, it remains at $16.5 billion — losing more than a third of its real value over two decades.
Second, setting it as a lump sum means it does not account for population growth. The total population under 18 has grown by over four million since 1995. Moreover, interstate differences in fertility rates means this population is growing faster in some states, particularly the Midwest and South. Some of those children are likely to live in families who fall into poverty at some point in their lives and require social assistance. States are increasingly expected to finance benefits for them with less federal funding. The result of these two shortcomings is that all states — but poor states in particular — are expected to do more with much less federal assistance.
There is no shortage of potential reforms that would increase the fiscal capacity in struggling regions. An agenda focused on big, structural change might emulate Canada’s federal arrangements, which combine a large equalization block grant with per capita block grants for health care, social assistance and education. A more modest incremental agenda would be likely to focus on reforming existing grants by shifting to formulas that make fiscal capacity and population the exclusive determinants of funding amounts.
Unfortunately, serious, detailed policy proposals are in short supply because the problem is not on policymakers’ radar. Writing back in 2014, the noted scholar of federalism Paul Posner (then the director of the public administration program at George Mason University) called it the debate we weren’t having. We still are not having that debate today. Although several presidential candidates have released plans to reform education and social assistance funding, there is no indication that they understand or appreciate the importance of interstate fiscal disparities.
This is arguably understandable. Debates over complex fiscal issues are hard to start in the best of times — and these aren’t the best of times. But until the issue reaches the front burner, there is little hope for reforms that meet the seemingly straightforward goal of consistently using the big federal assistance programs to reduce wide disparities in the states’ ability to meet basic needs.
related topics: Social Safety Net