522 July 15, 1986 STATES AND ClTlES PAY A HIGH PRICE FOR THEIR FEDERAL AID INTRODUCTION Powerful mayors and governors have been descending on Washington.

Their goal is t o spare from the federal budget cutters all of the 105 billion in federal aid now received by the nation's cities and states their localities may not be able to survive anger, however, is misdirected, for the federal aid that they have been receiving may b e more a curse than a blessing. Federal aid, for example, tends to prompt state and local tax hikes, encourages highly uneconomical projects, and widens the income disparities between the states. In short, the current federal aid structure causes the.rich states to get richer and the poor states poorer.

Federal aid to the states may serve appropriate national policy objectives in two cases. First, channeling federal funds to the states can be justified when the payments supplement state spending on project s of national significance. Federal grants to assist the states in operating and maintaining the interstate highway system may be legitimate because the spending benefits residents of all states.

Conversely, local roads ought to be built with state and lo cal tax dollars since community residents enjoy most of the benefits federal aid to the states may be necessary to ensure that all states even the poorest, are able to deliver a nationally defined minimum level of a carefully restricted list of services i n such areas as education, police and fire protection, and health. At most 20 states would qualify for federal aid under such a criterion Without every last penny of this aid, they argue angrily Their concern is as understandable as it is predictable. Thei r Second a The tragedy of federal aid, however, is that, despite more than 100 billion in outlays each year, no coherent national policy objective has been achieved. Clearly the current structure of federal aid needs overhaul. To replace the 300 fragmented grants-in-aid programs, Washington should establish a program of Fiscal Equity Grants to the states, similar to a proposal last fall by the Committee on Federalism and National Purpose-a private bipartisan Commission chaired by Senator Daniel J. Evans, th e Washington Republican, and former Virginia Governor, Democrat Charles S. Robb. Under such a system, only those states with tax capacities below the national average would receive federal assistance. The idea rests upon the premise that areas with an ampl e tax base to pay for services and projects themselves should not receive tax dollars from residents of other states By basing grant payments solely on need, the income disparities between the states would be lessened, while the poorest states would be ass u red of receiving adequate federal payments to provide residents necessary services federal spending while assuring assistance to the most deserving states. their addiction to federal aid. This aid has only expanded spending at all levels of government, wh i le transferring decisionmaking responsibility on local issues from the hands of community residents where it belongs into the hands of Washington bureaucrats. Worst of all, by accepting billions of dollars of federal aid each year, local governments have s ubjected themselves to the strangling grip of hundreds of federal regulations. Federal aid is a costly burden, not a benefit, to state and local taxpayers The Fiscal Equity Grants thus would reduce total 1 Most important, state and local governments must be cured of THE PROLIFERATION IN FEDERAL AID As Figure 1 indicates, after a brief slowdown in 1981 and 1982 federal aid to state and local governments is climbing rapidly again.

This federal aid consists not only of direct payments, but also of revenue for gone by the federal government in the form of deductible state and local taxes. In 1985 nearly $50 billion was ttlosttt in this way, bringing total federal aid to state and local governments to $150 billion for that year. This is an all-time record.

In hi s comprehensive analysis of the 1981 federal spending cuts Princeton University political scientist Richard Nathan concludes that 2FIGURE 1 Federal Grants To State and Local Governments in Cunent and Constant Dollars Plotted In millions for ffscal years 1 2 0000 100000 80000 1960 1963 1966 1969 1972 1975 1978 1981 1984 3opponents of the cuts exaggerated the magnitude of the reductions to garner resistance to them. In fact, only 17 states experienced absolute reductions in federal aid money for highway constr uction offset budget cuts.

For'the remaiping states new Ronald Reagan's federalism initiative mainly scaled back the number of grant programs; it has not stemmed the total outflow of federal dollars. When Reagan took office there were an estimated 500 sepa rate federal grants-in-aid programs to states and cities. The Office of Management and Budget reports that there now are just over 300, meaning greater flexibility--and thus efficiency--in the spending of federal aid. Yet duplication remains: this year, f or instance over 25 grant programs will aid the handicapped, eight will provide weatherization assistance, and seven will disburse funds for libraries.

FOUR MYTHS CONCERNING FEDERAL AID Each of the past three Presidents has strongly endorsed trimming While these claims may have federal aid to state and local governments have thwarted them. The critics of federal cutbacks have advanced four principal arguments for their case seemed plausible two decades ago, each by now is discredited by the evidence Powerf ul vested interests Myth 1: Cuts in federal aid force state and local tax hikes.

If this were true, then state and local taxes would be higher in years when federal aid was low, and lower in years when federal aid is high inflation-adjusted dollars, increa ses in state taxes correspond very closely with increases--not decreases--in federal aid to the states.

Similarly, reductions in state taxes are associated .with decreases in federal aid to the states. The same relationship hasJemerged between federal aid to local governments and local tax rates. Admittedly But just the opposite is the case. In per capita 1. Richard P. Nathan, Philip M. Dearborn, and Clifford A Goldman Initial Effects of the Fiscal Year 1982 Reductions in Federal Domestic Spending in John Ellwood, ed., lL Domestic SDendinQ Cuts: How Thev Affect Stat e and Local Governments (New Brunswick, New Jersey: Transaction Books, 1982). p. 320 2. "Study Cites Gaps in Federal Spending The New York Times, June 19, 1985, p. D27 3. The correlation betwee n per capita own-source state revenue collection (1 972 dollars and per capita federal aid to the states (1972 dollars) over the period 1954-1983 was .98.

The correlation between per capita own-source local revenue collection and per capita direct federal aid to local governments was .83 4extraneous factors could be causing these variables to fluctuate together contention that only the billions of dollars of federal aid disbursed by Washington each year have kept down state and local tax rates But at the v ery least, the evidence contradicts the popular There are, in fact, several reasons why federal aid increasps rather than decreases, state and local tax revenue and spending.

The majority of federal grants-in-aid programs impose a matching requirement on the state or local recipient. Thus federal aid is linked to taxes raised by a state or locality requirement is one local dollar for every four federal dollars.

The average matching This "free" federal money encourages local governments to fund programs tha t they otherwise could not justify by comparing costs and benefits. One survey of municipal projects receiving partial federal and state assistance, for instance, finds that 51 percent ofbthe projects would not have been undertaken without federal aid exp e nditures is that acceptance of federal grants-in-aid money subjects local governments to costly federal regulations. The Advisory Commission on Intergovernmental Relations (ACIR) has tabulated 1,259 federal regulations affecting state and local government s : over 1,000 of these were direct conditions of aid.6 The costs of these rules can be considerable the impact of just six of the more burdensome federal regulations on local governments Pound that they added 24 per capita to the cost of running city hall A nother reason state and local taxes rise with federal aid An Urban Institute study of Mvth 2: Federal aid reduces fiscal disBarities between the The best justification for federal aid to the states and local states governments would be that it reduced inc o me disparities among the and Oklahoma, receive less in federal aid than they contribute in I I services. But many of the poorest states, including Florida, Arizona, I states sufficiently for all communities to afford essential goods and 4. See Richard B. M cKenzie How Federal Aid Hikes State and Local Taxes," Heritage Foundation Backarounder No. 223, October 29, 1982 5. Catherine H. Lovell, gt al, Federal and State MandatinP on Local Governments: An Exdoration of Issues a nd ImDactS (Riverside, California: University of California Riverside, 1979 6. Quoted in: Murray L. Weidenbaum, "Strengthening Our Federal System," Journal of.

Contemborarv StudieS, .Fall 1981, p. 90 7. Ibid, p. 91 5taxes. By contrast, such affluent states as California and Alaska continue to walk off with the lion's share of federal funds. With a tax capacity three times the national average, Alaska received fo ur times the average federal aid in 19

84. And California received $395 per person more in federal aid than that state's residents paid out in federal taxes, despite having the fourth highest per capita income of any state.

Albert Davis and Robert Lucke e xamined the,1980 distribution of per capita federal aid weighted by population The higher capacity states received more per capita on average than the lower capacity states.11 This was confirmed when Davis and Lucke looked at 44 programs that supposedly b a se the size of an areals grant on its relative degree of,need for federal funds. Write the two researchers: "The grant system, as a whole, tends to distribute funds in favor of the wealthier states.'I In a comprehensive study of federal aid, former ACIR s t affers The authors found that I Figure 2 compares the financial condition of the federal government with that of the combined states and local governments state and local governments routinely have been in the black, while the federal government has been h opelessly in the red. The Congressional Budget Office projects that the federal deficit will remain far above $100 billion for the next five years. The stateeand locals, however,,oare expected to run annual surpluses of close to $100 billion by 1990 Since 1978 This maldistribution of federal aid has had serious effects on low income states population, for example, one study finds that ailing West Virginia would have created 10 percent more jobs in 1984 than it in fact did.

Michigan, with a 12 percent unemployment rate in 1984 was found tf have lost over 200,000 jobs because of the regressive aid system.

Mvth 3: The federal crovernment is in better fiscal shaDe than the states If federal aid had been based simply on a state's I

8. Albert Davis and Robert Lucke The Rich State-Poor State Problem in a Federal System,"

National Tax Journal, September 1982, pp. 337-363 9. Study by State Policy Research, Inc., findings quoted in: The New York Times Study I Cites Gaps in Federal Spending," June 19, 1985, p. D27 I

10. U.S. Department of the Treasury Report on Federal Regulations 1986 6FIGURE. 2 Federal and State-Local Annual Budget SurpludDeficit Annual rates plotted in billions, current year 7Mvth 4: Federal aid is needed because the states are not responsive t o the needs of local aovernments.

The facts refute this to localities has risen significantly. Between 1962 and 1982 the level of state aid in constant 1972'dollars rose about threefold-from 12 billion to 35 billion Over the past 20 years, state assistanc e State targeting to distressed areas also has improved. A recent study by Texas ACM political scientist John Pelissero concludes that although "state revenue sharing was not targeted to needy cities,Il during the early 19608, by 1976 state revenue sharin g was shown to be responsive to all three dimensions-social, economic, and f iscal--of city need lll DIVIDENDS FROM GREATER STATE AND XDCAL SELF-RELIANCE Cuts in federal aid typically are perceived as harmful to state and local taxpayers. The opposite is m ore likely true: taxpayers would benefit greatly from less federal involvement in activities primarily local in scope. Reasons for this are 1) Leaal constraints on sBendina force the states to be more innovative than the federal aovernment.

The constitutio ns of 47 states require balanced budgets and the vast majority of localities impose balanced budgets on their municipal governments. All but one state grant the governor the line item veto. These restraints force state and local governments to innovate in delivering services at lower cost services, for instance, is now routine in most municipalities. As a result, service delivery costs have been cut by anlzaverage of 30 to 40 percent without any diminution in service quality.

County recently estimated that it has saved taxpayers $23 million annually through its extensive use of private contractors, which provide, among,,other things, garbage collection, park maintenance, and street repair Privatization of a number of Los Angeles 11. John P. Pelissero State Revenue Sharing With Large Cities: A Policy Analysis Over Time," Policv Stud ies Jou rnal, March 1985, pp. 643-652 12. Privatization in the U.S Cities and Countiea (Dallas, Texas: National Center for Policy Analysis, 1985 p. 16 8Localities also have intro duced vouchers for education and medical care, volunteers and nonprofit groups to provide social services, and outside management consultants to cut the cost of data processing, cash management, procurement policy, and debt collection.

Indeed, while the federal government responds to fiscal crisis by going deeper into debt, the states and cities respond by administrative belt tightening and privatization 2) Reduced federal aid encouraaes efficiencv imn-ovements.

Miami recently completed construction of a 1 billion metro rail system. Ridership is so low and expenses so high that by one calculation it would have been cheaper for taxpayers to provide free limousine service for passengers than to build the system elephants go ahead for one simple reason: they a re built primarily with Ilfreell federal Urban Mass Transit funds, and they benefit developers, construction firms, and other powerful political interests. Since the local taxpayers pay a negligible share of the federal taxes that make the grant available , they have little reason to oppose such spending. Understandably, if local taxpayers had to foot the bill, such projects rarely would be considered Such white Understandably also, studies show that when local projects are purchased with local rather than f ederal tax dollars, there is far greater efficiency. Example: A Congressional Budget Office study of local spending patterns under the federally financed wastewater treatment program found llstrong statistical evidence that hisher cost shares are associat e d with increased investment efficien~y The Office of Management and Budget found that the availability of federal dollars for capital improvements encourages a deterioration of capital infrastructure. The reason: local governments often neglect basic upke e p for which they receive no federal funds, but because federal construction grants are available, wait until it is necessary to replace deteriorating infrastructure. The study noted that public facilities decayed mBst rapidly in the 1970s, when federal fu nds for public works peaked 3) Decentralization emx>owers .local tamavers.

Citizen participation in government decision making, notes the Advisory Commission on Intergovernme ntal Relations, is %est direct and most frequent at the local level.11 Taxpayers have far greater influence on local budgets than they do at the federal level. Over 70 I 14. Congressional Budget Office, Efficient Investme nt in Waste water Treatment Plant 1985, p. 21 15. Office of Management and Budget, "Budgeting for Capital Infrastructure: Which Level of Government," 1982 9percent of the states, for instance, require.municipalities to hold open hearings on the budget, allowing taxpayers a voice in budget proceedings.

Greater taxpayer influence at the local level permits communities to tailor public expenditures to their own needs and priorities, and to balance costs and benefits more exactly than they can by lobbying Congress. Many governors and mayors no w lobbying Congress for more aid, of course, complain that taxpayer resistance makes it difficult for them to replace federal projects with state and local spending.

But this is simply an admission that taxpayers have calculated that the costs are not wor th the benefits, or that the objective of the project can be achieved with a more economical approach. Rather than a legitimate objection to decentralization, this is a virtue THE 1981 CUTS IN FEDERAL AID Supporters of Reagan's 1981-1982 aid cuts maintain e d that federal spending reductions would spur greater economies and innovation in local service delivery without impairing service quality evidence supports this. Only minimal local and state tax increases generally were enacted to replace lost federal re v enue. Princeton political scientist Richard Nathan examined the responses of 14 states and 14 large cities to reduced federal funds. He found that the vast majority of the states used revenue hikes to replace less than 10 cents for every dollar in federal program cuts the local level were even lower Subsequent Replacement rates at Thus the Reagan federalism reforms did not lead to an acceleration in state taxing and spending As Table 1 indicates during the 1980-1982 period, when federal aid was slowing, th e annual rate of increase in state taxes fell significantly.

And state taxes continued to fall during the post-1982 economic expansion. By 1984, Illinois, Wisconsin, Pennsylvania, Minnesota Ohio, and other states were planning or had enacted major tax roll backs I 16. For a detailed analysis of this issue, see: Advisory Commission on Intergovernmental Relations, Citizen Particbation in the American Federal Svste m, 1979 17. Nathan, gt al, pp. 189-204 10 TABLE 1 ANNUAL RATE OF INCREASE IN STATE OWN-SOURCE TA X REVENUE AND FEDERAL AID RECEIPTS--1970-1982 Revenue Source Annual Rate of Increase 1970-1975 1975-1980 1980-1982 Total Federal Aid 13 4% 11.4% 1.1 Total Own-Source Taxes 10.8% 11.3% 8.8 Source: Table adapted from: Stephen D. Gold Recent Development in St ate Finances,Il in New Federalism: Its Imnact to Date, Hearings Before the Joint Economic Committee Congress of the United States, 1983, p. 235.

To be sure, there were declines in the growth of state spending including welfare programs that welfare spendin g was significqntly curtailed 1985 assessment of the Reagan block grant reforms by the General Accounting Office, for instance, "program continuity was rarely disrupted Overall program areas that had been funded under the categorical programs continued to receive support under the block grants l

l8 One key reason was that the cutbacks coincided with the consolidation of ,dozens of categorical programs into nine block grants. This gave increased flexibility to the states, enabling them to improve efficiency and thus blunt the impact of the cuts. States were generally able to hold down tax rates, absorb federal aid cuts and at the same time retain service levels without disrupting service quality through a combination of steps But it would be incorrect to co n clude According to a Chief among these are Cuts in administrative costs. The block grant consolidations and relaxed program auditing and reporting requirements allow state and local paperwork19requirements to be cut an estimated 5 to 6 million man hours a n nually. Over 30 states, moreover, merged and simplified state programs into local block grants, cutting local costs. By combining the Handicapped Children's program with the Maternal Child Health Block Grant, for instance, Montana was able to 18. General A ccounting Office, Block Grants Brought Fundinn Changes a d nA'm diust ents T o Program Priorities 1985 19. Edgar E. Vash, Testimony before the Joint Economic Committee pew Federalism: Its ImDact to Date, 1983 p. 481 11 I I reduce administrative costs20suf f iciently to expand program access to 11 percent more recipients asalaries and overhead by 9 million by collapsing nine public health programs into one state public health block grant And California cut administrative Priorities in s~endinq. The states qui c kly put their own imprint on spending levels for programs within block grants. Under the Social Services Block Grant--a Reagan Administration creation which combined about a dozen categorical programs--most of the states give high priority to such program s as child and adult protective services, education, training, adoption, and foster care programs while triping state spending on family planning and day care services. agencies, were eliminated by many states.

Other programs, including the23community acti on The substitution of state spending priorities for federal priorities was perhaps the most significant achievement of the Reagan federalism reforms response to federal aid cuts by George Peterson, Director of the Urban Institute's Public Finance Center: "The states' budget adjustments seemed to show that, as the administration intended, if forced to become reliant on their own resources. states would select verY According to detailed analysis of the state diffe&ent budget priorities than those coaxed fro m them by fed&al aid.

Lore strinaent needs-based criteria for social Droaram eliaibilitv. thirteen states that nine introduced new criteria for distributing funds under the Community Services Block Grant. The result of these new criteria is that poverty-ba sed factors play a more prominent role in spending. The states therefore have not turned their backs on the poor, as many social service organizations feared. Indeed the Coalition on Block Grants and Human Needs, an umbrella organization of over 100 group s that represent the poor and handicapped, acknowledges The states were far more progressive than we expected...on many social issues. fit2 The General Accounting Office found in their survey of 20. Ibid, 477 21. Ibid, p. 482 22. General Accounting Office, 9 cit, p. v 23. George E. Peterson Federalism and the States," in John L. Palmer and Isabel V.

Sawhill, eds., The Rewn Record Washington, D.C Urban Institute, 1984 p. 244 24. Ibid, p. 238 25. The New York Times 9~. cit, p. 32 12 - i Privatization. Contrac ting with private companies to provide The public services was a novelty in the 1970s. It now is routine.

National Center for Policy Analysis surveys of local governments discovered that reliance on private firms for service delivery increased by over 1,008 percent for a wide range of municipal services between 1973 and 19

82. Cost savings averaged 30 to 40 percent.

REFORMING THE FEDERAL.AID SYSTEM Since the enactment of the Reagan block grant reforms of 1981-1982, there has been little serious discussio n of fundamentally restructuring federal aid to states and localities. The Reagan reforms changed the nature of federalism, but they scarcely dented the colossal aid budget Reagan inherited. To do so would require a number of reforms. Among them 1) Establ ish a Fiscal Euui tv Grant for States.

The current federal aid system gives wealthy states too much and poor states too little. The U.S. intergovernmental grant structure should resemble more closely those of Australia, Canada, and West Germany, where the sole objective of federal payments to subnational units is to redress income disparities among these areas. Under such a Fiscal Equity Grant concept, state eligibility and the size of annual payments would be based exclusively on economic need. The Adviso r y Commission on Intergovernmental Relations computes annually a Tax Capacity Index" for each state. Those states with tax capacities above the national average would not qualify for federal funds; those with capacities below the average would receive gran t payments sufficient to maintain service levels at national minimum standards.

There is no compelling reason why the federal government should provide revenue to a state that has an adequate tax base, but s3plply chooses not to t ax its residents to provide necessary services 26. National Center for Policy Analysis, gb. ciL, p. 3 27. To make the proposal politically feasible, reduction in federal aid must be accompanied by expanding the state and local tax base through reductions i n federal taxes. The ACIR has compiled a scheme whereby spending reductions of $20 billion could be combined with revenue turnbacks of an equal magnitude. The plan has been devised in such a way that no state loses or gains benefits of more than 10 percen t . The patterns of gains and losses, however, match the state's level of fiscal need. For details, see Advisory Commission on Intergovernmental Relations, Devolvina Federal Program Resbonsibilities and Revenue Sou r ces to SWe a nd Local Governments, March 1986 13 2) Continue to consolidate federal aid Droarams throuah block arants.

A necessary step toward the Fiscal Equity Grants would be to collapse the over 300 existibg federal grant programs into about twelve IISuper-Block Grants Rather than having over 30 Department of Transportation grant programs, for instance, there should be one payment to state and local governments for transportation give communities an incentive to spend those federal funds more efficiently, and permit them to take advantage of block grant flexibility to tailor municipal programs in the interests of the community This would 3) Terminate most develoment assistance arants.

Dozens of federal programs provide general development assistance to state and local governments, including Ge neral Revenue Sharing Urban Development Action Grants, and Community Development Block Grants. Though each was designed to create employment in distressed areas, money actually tends to flow to affluent or politically powerful states and jurisdictions. s9 T hese grants, moreover, help developers rather than development. It makes little sense for the federal government, with its 200 billion deficit, to aid states and localities that are running healthy annual budget surpluses 4) Discontinue direct federal ass istance to local aovernments.

If it is the federal government's role to reduce excessive disparities among the states, then it is the states' responsibility to remove such disparities between localities within their borders states have greatly expanded the fiscal assistance they provide to their localities-and targeting to needy areas has similarly improved. The states have the capacity and experience to take a larger role in community assistance The They should do so CONCLUSION The framers of the Constitu t ion conceived federalism as a device for cooperation and as a barrier to prevent intrusion by one level of government into the affairs of another. In recent decades, the 28. The concept of "Super Block Grants" was proposed by the Reagan Administration in 1982 but was stalled and forgotten before it received a thorough public hearing 29 For example, see "Urban Grant Program Is on the Defensive The Was hineton Post February 20, 1985, p A

4. See also Peter Ferrara, "Time to End Wasteful Urban Development Gran ts," Heritage Foundation Backgrounder No. 419, Mar.ch 26, 1985 14federal government has become involved in activities that traditionally have been reserved to the states and local communities determining which states receive how much, federal aid has fail e d to promote any clearly defined national objective. Wealthy states receive larger shares of the federal assistance pie than the relatively poorer states, and states and localities are routinely discovered spending federal tax dollars on uneconomical proj ects since passing up "freevv federal dollars would be unthinkable.

Moreover, instead of federal aid helping to trim taxes on the state and local level, increases in federal assistance invariably have been matched with increases in own-source local spendin g Because political considerations are the deciding factor in The Reagan Administration has made useful changes in the grants structure. But so far the reforms have been at the margin. What is needed now is a commitment to terminate the potpourri of assis t ance programs, and replace them with a Fiscal Equity Grant based on the financial capacities of states to meet clearly defined needs. This would benefit poorer areas to a far greater extent than the present aid structure, and it would be a decisive victor y in the campaign to control federal spending.

Stephen Moore Policy Analyst 15 FIGURE 1 Federal Grants To State and Local Governments in Current and Constant Dollars Plotted In millions for fiscal years c 120000 100000 80000 60000 40000 20000 0 1960 1963 1 966 1969 1972 1975 1978 1981 1984 FIGURE 2 Federal and State-Local Annual Budget Surplus/Deficit Annual rates plotted in billionS. current year 100 State-Local Governments 50 0 50 100 Federal Government 150 200 250 I 1960 1963 1966 1969 1972 1975 1970 198 1 1984 1987