Fractured Fiscal System
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Fiscal relations between the states and federal government may be at an all-time low.
By Carl Tubbesing and Vic Miller
April 2007
Bone stress fractures are unbearably painful. Ask any basketball player who has tried to play with one. Stress on a weakened bridge truss is dangerous. Ask any civil engineer who has done the computer modeling. And the stress that has built up in fiscal relations between the states and federal government is painful to the states and dangerous to the long-term health of the federal system. Ask any appropriations chair trying to balance a state’s budget.
For two decades, unfunded federal mandates have symbolized the growing fracture in state-federal fiscal relations. Most legislators can readily name the current offenders—the Individuals with Disabilities Education Act, No Child Left Behind, the Help America Vote Act and homeland security. And they are girding for the possibility of the next huge one, the Real ID act. The National Conference of State Legislatures estimates that the federal government has shifted $100 billion in costs to states over the past four fiscal years—not including the $11 billion that Real ID could cost states over the next five years.
Those numbers are staggering, but they barely begin to describe the range and magnitude of fiscal stress that has come to characterize the country’s federal system. To get a sharper picture, we need to enter the green eyeshade world of grants-in-aid, block grants, categorical grants, entitlements, clawbacks and trust funds. We need to explore the fundamental effects that changes in this seemingly arcane world have on the role of the states in the federal system. Let’s start with a Cliff’s Notes history of 200 years worth of state-federal fiscal relations.
For most of the country’s first 200 years, the federal government was fiscally weak. It didn’t tax much, except in wartime, financed itself through customs revenues and land sales, and shared little, if any, of the few revenues it mustered with the states. This changed with the Great Depression of the 1930s. The national government used the income tax and deficit spending to stimulate the economy and fund the New Deal. Much of the program was administered by the states, funded by money supplied by the national government. By the end of World War II, the federal government, which had been in a fiscal slumber for almost two centuries, suddenly was dominant. In 1948, its revenues tripled those of all state and local governments combined. This dominance eased through the 1950s and 1960s. During the 1970s, 1980s and 1990s, federal revenues were approximately double those of state and local governments.
The national government’s fiscal problem today: It is spending more than it is taking in. Federal revenues and spending as percentages of gross domestic product—in other words, as shares of the economy—illustrate this. The decade began with federal revenues peaking at about 21 percent of the economy, but they currently are in the 16 percent to 18 percent range. By contrast, in the same period, federal spending has grown from 18 percent to 20 percent of the economy. David Walker, the comptroller general of the United States, the Concord Coalition and other groups are conducting forums throughout the country to raise the alarm about the short- and long-term effects of this federal deficit. It is a very grim picture. For an overview, read Ominous Outlook, from the June 2006 issue of State Legislatures magazine.
The effect of recent federal revenue and spending practices has constituted a radical alteration in fiscal relations among the national government and the states. These practices fall into three categories. Federal grants-in-aid to states have become more restrictive and specific. The national government is making increasingly greater use of state money. And, the incidence and amount of unfunded federal mandates have increased exponentially. Together, the changes mean that federal grants to states now direct state spending rather than support it and that the national government now uses state and local government revenues for its purposes rather than providing grants to support theirs.
From No Strings to Strings
The federal government makes money available to state and local governments through different kinds of grants-in-aid. Grants vary greatly, but they share the objective of making a service available to the public—building a highway, providing vaccines, offering job training, teaching disabled students, and so on. They can be arranged along a continuum. At one end of the continuum are federal funds that have come to states with few, if any, strings attached. At the other end are those that come with very specific requirements on state governments’ use of the money.
At the “no strings” end are general purpose grants. Epitomized by President Richard Nixon’s general revenue sharing program of the 1970s, general purpose grants come with few, if any, limitations on how they are to be spent. They have been used primarily to stimulate the economy and to ensure that state governments—especially those with weak economies—can provide services during economic downturns. Because state governments must balance their budgets, their response to a weak economy—cutting services and raising taxes—has the effect of prolonging or deepening a downturn. Unimpeded by a balanced budget requirement, the federal government uses general purpose grants to help states and the country pull out of the downturn. The most recent example came in fiscal years 2003 and 2004 when state legislators, working with a bi-partisan group of five U.S. senators, secured $20 billion to ease states through the recession in the early part of this decade.
Next to general purpose grants on the continuum are block grants. Block grants are targeted to a service or a range of services—welfare or maternal and child health, for example—and, in theory at least, provide states considerable flexibility in how to spend the money. Moving further along, are two kinds of categorical grants, both of which come with plenty of strings. They differ in how the funds are distributed. Formula categorical grants, such as Low Income Home Energy Assistance, are distributed among the states by formula. Discretionary categorical grants earmark money for a specific purpose or give a federal agency broad latitude in allocating the funds.
The continuum ends with two kinds of grants that require state governments to spend money in order to access the federal money: entitlement programs, such as Medicaid, and transportation trust fund grants, such as the highway fund. They require states to match the federal money or maintain a certain level of fiscal effort—or both.
The four-decade history of grants-in-aid indicates a clear movement from no strings to lots of strings. With the exception of the 2003 fiscal relief funds, general purpose grants have mostly disappeared. Last year’s renewal of the welfare (TANF) law shows how vulnerable block grants are to being encumbered by federal conditions—how easily flexibility turns to rigidity. And, driven largely by growth in the Medicaid program, legislatures find themselves using more and more state money to support federal entitlement spending.
What’s Wrong With This Picture?
Medicare Part D, the new Medicare prescription drug benefit that took effect January 2006, achieved considerable notoriety among consumers, pharmacists, and drug and insurance companies. It managed another kind of notoriety for how it was financed—by forcing a contribution from the states that can only be described as a direct federal tax on state governments—single-handedly establishing a new category at the end of our continuum.
As Congress and the administration negotiated over a Medicare prescription drug benefit during 2003, several things became clear. One, the benefit would be very, very expensive. Two, there would be no “normal” tax increases to finance it. And, three, the negotiators would have to be very creative to find other ways to pay for it. One of the latter is the “clawback”—a monthly payment from the states to the federal government that initially funded about 20 percent of the benefit—in other words, a tax on state governments. Over the first five years of Part D coverage, it is estimated that states will have to pay almost $50 billion to the federal government from their general funds, the largest single flow of funds from states to the federal government in support of a totally federal program.
Congressional transportation earmarks are another way the federal government mandates state priorities. The latest surface transportation law—SAFETEA-LU—contains $22.1 billion in earmarked highway projects and another $2.1 billion in earmarked mass transit projects. These earmarks come from the dwindling highway trust fund. They substitute federal government priorities for those of state legislatures and transportation departments.
The Consequences
Substituting federal priorities for state priorities is not new. That is, after all, what federal unfunded mandates do. With No Child Left Behind, the federal government imposed numerous testing, reporting and intervention requirements while paying only a fraction of their costs. The Help America Vote Act told states how to run elections, then left them holding a $725 million bag. The Individuals with Disabilities Education Act, the longest-running federal unfunded mandate, promised that the federal government would pay the excess cost of educating a special education student. But the best it’s ever done was about half of what was promised. And, unless Congress soon has a collective epiphany of conscience, state legislatures will have to find at least $11 billion to fund Real ID, the federal vision of a secure driver’s license system.
What is relatively new is the federal government’s use of other tools that cause states to spend money. The potential effect of all of this—the unfunded mandates, underfunding, clawbacks, earmarks and their fiscal cousins—is to sap states of their vitality. State innovation—one of the great strengths of the country’s federal system—doesn’t always require money. But the more the federal government commandeers state revenues for its purposes, the less there is for state legislatures to pursue their own priorities and to be responsive to the unique cultures and demands of their constituents.
Carl Tubbesing is NCSL’s deputy executive director. Vic Miller, senior fellow at Federal Funds Information for States, is an expert on Medicaid and other state fiscal conundrums. He is the author of the paper. “Trail of Broken Promises,” on which this article is based. It was funded by a grant from the Foundation for State Legislatures.