Federal Aid or Fiscal Burden? Estimating the Impact of Federal Intergovernmental Grants on the State

View the Study (pdf)

Results of the Study

Based on a standard econometric model and a 30-year panel data set of federal grants and state taxes, a study finds strong evidence that federal grants-in-aid result in significant upward “ratcheting” of state taxes over time.

The study found that each dollar of federal aid leads states to boost spending by about 45 cents in that year, 61 percent of which results in permanent state budget obligations that must be financed by higher state-local taxes.

In addition to the hidden budgetary costs of federal grants-in-aid, accompanying grant rules and regulations can have a significant effect on the ability of states to maintain local political control over key areas of state and local policy.

Key Findings

The study predicts that each $1 of federal grants increases state taxes between $0.221 and $0.274 in the long run, primarily state personal and corporate income taxes and general sales taxes.

In North Dakota, federal grants amounted to $2.17 billion in 2010, more than one-third of total state and local expenditures. At over $3,200 in federal aid per resident.

Today, North Dakota ranks as the 6th highest recipient of federal grants in the nation.

The traditional view among state lawmakers is that federal grants represent a “free lunch” from Washington. Federal aid allows states to expand popular government programs without relying on local tax revenue—an institutional arrangement that yields benefits both to state residents and local lawmakers. However, a growing number of economists have begun questioning the conventional view that federal aid represent a simple transfer of resources from Washington.

Unintended Consequences of Growing Federal Grants:

• Growing demands on state resources
  

  More recent studies have found evidence that these temporary federal grants often give rise to permanent state spending programs and expanded public sector payrolls, ultimately requiring higher state and local tax revenue than would have prevailed without the influence of federal grants.
  

• Loss of local control

  Federal grants are routinely accompanied by regulatory requirements—so called “strings attached” dollars.
  
  

• Expanded Bureaucracy

  As the scope and complexity of federal aid programs has grown in recent decades, it has given rise to an increased number of dedicated staff within state and local governments responsible for managing application and reporting processes required by federal rules. These administrative burdens represent an additional ancillary cost of accepting federal aid, which has in some cases been reported to exceed the dollar value of the corresponding federal grant.

The passage of the 2009 federal stimulus bill led to rapidly increasing federal aid to the state, reaching an all-time high of $3,219 per person in 2010, roughly triple the level of three decades ago in real terms.

The Good Intentions and the Bad Results of Federal Grants:

Federal grants intended to provide temporary support often transform into health, transportation and public safety programs that become a permanent feature of state budgets. When grants expire, lawmakers often respond by increasing state taxes rather than face the political costs of budget cuts and layoffs for public employees.

In other cases, federal grants are specifically designed to provide “pilot” funding for state projects, which intentionally increase demands on local funding sources in future years.

According to the study, we find one dollar of federal grants lowers state tax burdens by an average of $0.46 in the current year but ultimately results in higher state tax burdens of roughly $0.22 in the future.

Federal Grants Effect on State Taxes

Of the state taxes examined, federal grants have a significant upward effect on three:

1. Personal income taxes by roughly 13.5 cents
   
2. Corporate income taxes by 3.5 cents
   
3. General sales taxes by 2 cents
   

Overall, we find strong evidence that federal grants-in-aid result in significant upward “ratcheting” of state taxes over time. Each dollar of federal aid leads states to increase spending by roughly 45 cents in the same year.

• In future years, roughly 27 cents or 61 percent of this spending results in permanent state programs financed by higher state own-source revenue. We find this effect in every subsample of the data examined, including states with similar legal and political characteristics to North Dakota.
  

Overall, we conclude there is good reason to doubt the conventional view among state lawmakers that federal grants-in-aid represent a “free lunch” from Washington. To the contrary, federal grants appear to impose significant hidden budgetary costs on recipient states in the long run.

We find federal aid to North Dakota led to indirect state tax increases of between $128 and $1,181 per capita per year between 1995 and 2010, with an average annual tax increase of between $375 and $711 per person per year. Over the 16-year period, this amounts to an effective state tax increase of between 6.5 percent and 31.8 percent compared to a baseline of no federal grants, with a mean tax increase of 19.2 percent. Similarly, we find federal aid increased North Dakota’s own-source revenue by between 6.5 percent and 24.8 percent, with a mean upward “ratcheting” of 15.6 percent.

Regulation

When states accept federal grants-in-aid they are required to follow all of the rules and regulations that come with it. Sometimes these mandates are few and only affect the subsidized activity. Other times they are much more onerous and far reaching.

In addition to distorting state outlays toward spending on transportation, acceptance of federal highway funds has subjected North Dakotans to federal mandates such as those described below:

• Billboard removal
• The 55 mile per hour speed limit
  
• The national minimum drinking age
  

Much of power that the federal government has assumed over transportation stems from its control over the purse strings of the Highway Trust Funds.

Medicaid

Because Medicaid is an entitlement there is little that that states could do in the short-run to rein in spending. Under the balanced budget requirements that most states operate under, this means that taxes have had to be raised or large cuts in popular programs had to be made.

When states agreed to participate in the federal Medicaid program in the late-1960s they surrendered much of their autonomy over state health policy to the federal government. As Medicaid spending has grown rapidly over the last four and half decades they have increasingly lost control over other parts of their budget as well. Several states have had moderate success cutting federal tentacles and regaining control over their state budgets. Unfortunately North Dakota has not been a leader in Medicaid reform.