Fiscal Federalism II

As I pointed out in the first installment of this series, fiscal federalism today is dominated by money flowing from the federal government to state and local governments.  There are many side-effects of this inversion of fiscal federalism that I believe are detrimental to the American Republic.

A new study by Professor Russell S. Sobel and George R. Crowley sheds light on a particularly disturbing aspect of federal spending–the inducement of higher state and local taxes.  How?  Many grants to state and local governments are “temporary” in nature, yet when the federal funding dries up the recipient government feels political pressure to keep up the new spending.

For example, consider the U.S. Department of Justice’s Community Oriented Policing Services (COPS) hiring grants, whose purpose is to fund new officers to town police departments.  However, the catch is that towns that receive such grants must pick up the tab in the fourth year and beyond.  Here is an article summarizing the plight of a small town in Delaware facing such a challenge with the COPS grant.

In the end, the author’s conclusions are rather startling:

Most importantly, our results suggest that the recent large increase in federal grants to state and local governments that has occurred as part of the American Recovery and Reinvestment Act (ARRA) will have significant future tax implications at the state and local level as these governments raise revenue to continue these newly funded programs into the future. Federal grants to state and local governments have risen from $461 billion in 2008 to $654 billion in 2010. Based on our estimates, future state taxes will rise by between 33 and 42 cents for every dollar in federal grants states received today, while local revenues will rise by between 23 and 46 cents for every dollar in federal (or state) grants received today. Using our estimates, this increase of $200 billion in federal grants will eventually result in roughly $80 billion in future state and local tax and own source revenue increases. This suggests the true cost of fiscal stimulus is underestimated when the costs of future state and local tax increases are overlooked.