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June 2006

June 2006 Contents

Federalism at a Crossroads

William T. Pound is NCSL's executive director.

The U.S. federal system is the most vibrant and effective federal system in the world. It is always dynamic, always evolving.

In large part, the success of federalism is a result of the creativity and innovation of the states. Yet the federal balance today is placing enormous strain on state budgets as the national government enacts initiatives and tells the states to pay for them. From the No Child Left Behind Act, to Medicaid reform, clean air and water, the federal government is asking states to do more--and come up with the money to do it.

PHASES OF FEDERALISM
It wasn't always that way.

America began with a state-based federalism where the states wielded most of the power and initiated nearly all domestic policy. That began to change with the Civil War. It shifted even more with World War I, the Great Depression and World War II, and evolved into its second phase--a clearly Washington-dominated federalism where Congress and the administration became the principal players. Relative to the federal government, the states became weaker. In fact, an observer of federalism commented that by the late 1950s, the states had become mere administrative arms of the national government.

Washington, D.C.-dominated federalism began changing around 1980, however, when President Ronald Reagan took office. Responsibilities and authority became much more balanced between the states and the national government, with both playing significant roles. State governments, and particularly state legislatures, had modernized in the 1960s and 1970s--from professionalizing their staffs to enhancing their research, bill drafting and budget capabilities. It wasn't very long before every legislature had its own fiscal staff to strengthen its role in the state budget process. Legislatures also created the National Conference of State Legislatures in the mid 1970s to make the states more active players on the national scene.

FISCAL FEDERALISM
One of the distinctive features of U.S. federalism is that it is the only major federal system in the world in which the national government doesn't systematically share revenues with state government. In the past, the federal government shared revenues with the states to overcome regional disparities. But that doesn't happen in a single program today. Revenue sharing occurs to some extent through Medicaid and in a few formula programs, but the funds are tied to a specific outcome. It's not general purpose aid.

Just as general purpose aid has all but disappeared, there also has been a decline in federal support for state and local programs. Three significant changes have occurred:

• More federal money goes to individuals today than to state or local governments. Federal money is targeted to entitlement programs much more than before, with Medicaid being the primary example. 
• Federal assistance to the states requires a significant match when compared to the 1950s to the end of the 1980s or early 1990s. For example, Medicaid is almost an equal split, although the very poorest of states can provide as little as a 20 percent contribution. And the highway program has a rough 80/20 to 75/25 split, with a 20 percent match being the general standard to receive federal money. But perhaps even more important than the size of the match is that federal action drives state decisions and determines what the states have to do with those programs.
• Programmatic responsibilities have shifted to state and local governments. In this period of balanced federalism, the federal government has devolved responsibilities to the states. The Medicaid program that began at the federal level has become a shared program and is the second largest component of state budgets. It's also the fastest growing one.

Local government responsibilities in environment, health care and education have been transferred to the states, too. It wasn't very many years ago when the states had very little responsibility over air and water quality. They also had very little to do with garbage and waste management. Now, many of those are state-run programs, partly because their complexity increased and partly because they exhausted the ability of local jurisdictions to deal with them--especially in some of the eastern states. Other areas have been affected as well. States have assumed a greater role in supporting K-12 education, and now fund about 51 percent of K-12 education costs.

In fact, states have assumed a greater funding role for many programs traditionally funded by local governments, in large part to support property tax relief efforts. By moving funding to a state's broader tax base, financial pressure at the local level is relieved.

But states also have taken on the responsibility for funding K-12 education because of the demands for educational equity and adequacy. More recently, there are federally imposed standards that states must meet.

The federal No Child Left Behind Act illustrates the relationship between decision- making at the national level and the impact at the state level. The law clearly has driven state funding increases, much more than the federal government has contributed to its cost. There's simply no question about that--state legislators have seen new funding demands generated by the implementation of the act.

There's another twist. States already are experienced with litigation around providing public education, but now the adoption of minimum federal standards is creating the basis for a whole new kind of lawsuit. States, not local school districts, are being sued over the standards. Kansas and Texas certainly can attest to that from their recent special sessions in which they wrestled with the question of educational adequacy and how to defend it. This is one direct way that a federal decision establishing a set of standards is now being used to guide some decisions in state government.

Medicaid is another area of concern in this latest phase of federalism. Medicaid funding, including both federal and state revenues, represents about 22 percent of total state spending and could rise to 24 percent by the end of 2006. States are virtually being taxed under the Medicaid "clawback" provision. This poses long-term and serious fiscal consequences for states. Some argue that it simply cannot continue.

Although the annual growth rate in Medicaid expenditures has been as low as 3.5 percent to 4 percent, in more recent years it has reached nearly 13 percent. But whatever the rate, Medicaid growth consistently outpaces the growth rate in state revenues. Last year, in fact, overall state revenues grew about 2.5 percent to 3 percent, while expenditures grew between 4 percent and 4.5 percent. Medicaid spending was a primary cause.

THE REVENUE MIX
From the mid 1990s to 2000, federal government revenue grew about 8 percent to 10 percent annually; state government revenues, about 5 percent to 6 percent a year; and local government revenues, about 2 percent to 3 percent. This is instructive for considering the capabilities of the various revenue systems.

The federal government has the largest share of income tax revenues, so these varying percentages suggest that the income tax is the most effective tax at raising revenue. States vary in the extent to and percentages at which they tax income. They also rely heavily on sales and use taxes. Telecommunications taxes and other similar levies traditionally are within the purview of local governments, much more than they are for either the federal or state governments, which place locals in the weakest position of all.

The capacity of the federal system to produce revenue has been reduced since the year 2001, when President Bush initiated federal tax cuts. Over time, the states generally have increased their revenue capacity, although they cut taxes during the late 1990s when revenue growth was booming. Notwithstanding those reductions and subsequent fiscal stress, state revenues now are doing as well as or better than they were in 2000, just before the economic downturn hit.

TODAY'S TAX CHALLENGES
We live in a rapidly changing economic environment and fiscal fortunes can turn quickly. State lawmakers not only need to be concerned about the health of the economy, but also the structure of their tax systems and the effects of federal tax policy decisions.

State tax systems do not capture economic activity to the extent they did 30 years ago. State sales taxes are primarily on goods, with only three states applying their taxes to a broad range of services. Yet the U.S. economy is now primarily service based.

Federal government decisions that may be made in the next two or three years also will have considerable impact on state revenues. President Bush's Commission on Tax Policy produced a report in October 2005 that had several recommendations. One that would affect state governments most would remove the deductibility of state and local taxes from federal income tax calculations. If implemented, that recommendation probably would make it more difficult to raise taxes at the state level.

Moreover, most state revenue systems are tied to the federal revenue system, particularly the income tax. States use the same definitions as the federal government and usually assess state income taxes based on a certain percentage of the amount paid in federal income taxes, with adjustments. That means that any federal income tax changes would have a subsequent effect on state tax collections.

That illustrates another interesting feature about today's federalism: The federal government has shown little concern for state and local governments in recent revenue decisions.

Two past examples are accelerated depreciation and the estate tax. Raising the rate of accelerated depreciation drove down state revenues because most states were tied to it. Federal estate tax changes were made with virtually no consideration of how this affected the state portion of the tax.

This concern also extends to future federal policy. A proposal to enact a federal value-added tax is still pending.

One reason for the exploration of new federal levies is the national deficit. It is so large (the equivalent of $156,000 for every resident of the United States or $411,000 for every household) that many believe that the federal government will have to increase revenues. In fact, a former Reagan administration official was quoted as saying that federal taxes would have to be raised to address the deficit. And the value-added tax is the most likely way to do it.

The value-added tax has huge implications for state governments, particularly for the 45 that levy sales taxes. Can state sales taxes and a federal value-added tax coexist and, if so, at what level? What collection tool would be used? The easiest way for the federal government to collect a value-added tax would be to let the states collect it because they already have collection mechanisms in place.

FEDERALISM'S FUTURE
The state-federal partnership largely is defined by which level of government provides services and which one funds them. As demonstrated over the past decade and longer, the federal government's pattern is to enact national policy initiatives but ask the states to pay for them. These unfunded and underfunded mandates are placing enormous strain on state budgets. Concurrently, federal revenue decisions are affecting, and even undermining, state tax collections. And future federal revenue actions could be even more alarming. In combination, federal policy is threatening long-term state fiscal stability. 

But today's situation is not set in stone, and much change is likely in federal and state revenues and expenditures. State legislatures must do their part to define federalism and shape the future.

If they fail to do so, it will be at their peril.

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