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November 2015 Policy Study, Number 15-9


Impact of Federal Transfers On State and Local Own-Source Spending





How does federal money flowing to states affect state and local government spending? This has been a question since the United States’ first experiment with revenue sharing, nearly 200 years ago. In 1835, the federal government enjoyed a budget surplus. In addition, forecasts at the time projected federal surpluses into the foreseeable future. Congress decided to distribute the surplus to the state governments, based on population. The thinking was that states would use the money to fund additional public works. In other words, it was expected that state governments would use the grants they received from the federal government to increase state and local spending, without increasing state and local taxes.


Federal intergovernmental transfers—usually in the form of grants—are a significant part of state and local budgets (hereafter, unless stated otherwise, “states” should be understood to include state and local governments). The first annual cash grant was made under the Hatch Act of 1887. The Act is still in effect and more than $56 million was distributed to states in 2014 under the Act. By 1980, federal transfers to states had grown to $74 billion a year. By 2012, these transfers grew to almost $300 billion a year. In 1980, federal transfers amounted to about 3.2 percent of total personal income. By 2012, the amount had grown to 4.2 percent of total personal income.


The stimulus package known as the American Recovery and Reinvestment Act, enacted during the recession of 2008–2009, revived interest in the effects of federal intergovernmental transfers on state and local budgets and raised the following questions:


  • Does temporary state and local spending induced by federal grants disappear from state and local budgets when grant provisions expire; or
  • Do federal grants have a lasting effect on state budgets, with temporary aid giving rise to permanent state expenditure programs that ultimately require increased state and local revenue?

Indeed, concerns about a “ratchet” effect on state budgets were cited by several state lawmakers who considered refusing stimulus money from the federal government. For example, in early 2009, Louisiana’s Governor Jindal issued a statement saying Louisiana would not participate in a federal stimulus program aimed at expanding state unemployment insurance coverage.


Most federal grant programs are small and serve narrow purposes. A few large programs, however, such as Medicaid and the Highway Planning and Construction program, dominate the grant-in-aid system.


Looking forward, implementation of the Affordable Care Act is raising the issue of the extent to which the Medicaid expansion provisions will affect state and local taxes in those states that opt to expand Medicaid coverage. As enacted, the Affordable Care Act broadened Medicaid’s reach to include nearly all low-income Americans with incomes up to 138 percent of the federal poverty level. A Supreme Court ruling on the ACA gave states the option of implementing the Medicaid expansion. For states that expand, the federal government will pay 100 percent of Medicaid costs of those newly eligible for Medicaid from 2014 to 2016. The federal share gradually phases down to 90 percent in 2020. In 2013, Medicaid accounted for 15.1 percent of spending from state general funds and other non-federal amounts that are not a part of general funds, such as provider taxes levied for Medicaid purposes. A significant expansion could place substantial burdens on state budgets—even with federal funds covering 90 percent of the costs of expansion. This raises the question whether states will divert spending from other programs or increase taxes to fund the states’ share of the increased costs of Medicaid expansion.


Federal grants are expected to serve purposes beyond returning resources to taxpayers in the form of state and local services. It is argued that grant programs encourage states to spend federal funds on activities, projects, and services for which they otherwise would have spent less. The amount of additional spending is affected by the degree to which federal grant funds encourage more or less spending from states’ own-sources.


Figure 1 :      Illustrative impacts of $2 in federal grants on state spending from state and local revenues


Conceptually, the impact of federal transfers on state and local budgets is ambiguous. Theory indicates that state and local spending could grow, shrink, or stay the same, depending on how state and local governments respond to the additional federal funds:


  • Federal funds crowd-out state funds on a dollar-for-dollar basis. State services remain at pre-grant levels. As shown in the second bar in Figure 1, the federal funds replace state own-source funding (e.g., funds from taxes, fees, and other state and local sources). In this way state spending from own-source revenues declines, and is ultimately returned to residents through lower taxes or reduced fees. Because federal funds replace state own-source funds dollar-for-dollar, the federal spending is said to crowd out state and local spending.
  • Federal funds fully supplement state funds. As shown in the third bar in Figure 1, federal funds are added on top of state own-source funding. In this way state spending from own-source revenues is unchanged, but total state spending increases. This result is widely known as the flypaper effect, a term coined by Arthur Okun, who remarked that the money the government sends out “sticks where it hits.”
  • Federal funds stimulate state spending. As shown in the fourth bar in Figure 1, federal funds are added on top of state own-source funding and stimulate additional state spending. A review of the literature reports that most studies find that spending is stimulated by much more than theory would predict. A review of numerous studies—done with a variety of approaches and data sets—finds that at the low-end, a $1 increase in federal grants increases the spending of state or local agencies by 25 cents.[1] The review finds that at the high end, federal grants stimulate a dollar-for-dollar increase in state or local spending.


The U.S. Government Accountability Office identifies two ways that strings attached to federal grants can increase state spending: (1) matching fund requirements, and (2) maintenance of effort requirements.[2]


Many federal grants require that state or local governments contribute their own funds in order to receive federal matching funds. Economic theory suggests that grants requiring matching funds result in less substitution than those that do not require matching. It is argued that, by lowering the effective price of aided programs relative to other state spending priorities, they encourage states to spend more of their own funds. Matching requirements may stimulate state spending by encouraging states to engage in and fund projects or deliver and fund services that they would not undertake without the matching funds. For example, consider a hypothetical light-rail transportation project with a $200 million construction cost and requiring a $5 million a year subsidy for operations. The local government would not go forward with the project at $200 million in construction costs. However, with federal matching funds, the locality’s share of constructions is $100 million, and the local government chooses to move forward with the project. Because of the federal matching funds, the locality is burdened with an additional $100 million in spending for construction, plus an additional $5 million in operating costs that would not be incurred if the project had been rejected. These additional funds must come from existing programs or additional revenues in the form of taxes, fees, or charges.


Maintenance-of-effort requirements demand states maintain existing levels of state spending on an aided program as a condition of receiving federal funds. By requiring states to maintain a given level of spending from their own funds in addition to the federal grant funds they receive, maintenance-of-effort can prevent substitution in those programs where there is no federal matching requirement or where state spending exceeds the minimum required state match. For example, the American Reinvestment and Recovery Act—more commonly known as the “stimulus package”—had a provision that required states to provide a minimum threshold state appropriation to higher education of not less than the 2006 state appropriated levels. States falling under the maintenance-of-effort threshold would be in jeopardy of losing significant federal stimulus money. A publication of the American Association of University Professors concludes that state appropriations data clearly show that the threat of loss of federal funds was the key driver of higher education budgeting decisions for many states.[3] For example, for 2010, Oregon matched the federal threshold amount precisely. Nearly a dozen other states came in just over the minimum in 2010. In this way, maintenance-of-effort requirements caused states to spend more on higher education in the wake of the Great Recession and shrinking state budgets than they would have otherwise. This in turn, led to pressures to raise taxes. For example, in 2010 the Oregon legislature referred—and voters approved—two tax measures amounting to a $727 million state tax increase.


In addition to the strings attached to federal funds, research points to a “ratchet effect” in which spending in response to a temporary crisis becomes a permanent increase in spending. Similarly, additional spending from a one-time revenue windfall can become a permanent program as staff are employed and residents receive services, thereby establishing and entrenching interest groups in support of program. Recent research into the ratchet effect published in the widely cited academic journal Public Choice finds that each dollar of additional federal grants to states is associated with a tax increase of 31–40 cents at the state level and 23–46 cents at the local level, for a total increase of 54–86 cents in new state and local taxes.[4]




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