Chapter

15 United States

Editor(s):
Teresa Ter-Minassian
Published Date:
September 1997
Share
  • ShareShare
Show Summary Details
Author(s)
Janet G. Stotsky and Emil M. Sunley

The federalist system of government in the United States is an overlapping structure of federal, state, and local governments. Subnational governments play a much larger role in American political life than in most other countries, reflecting the country’s historical roots in a tradition based on participatory democracy and checks and balances on the power of government. In 1990, there were 50 states and 83,186 local governments, encompassing municipalities, townships, counties, school districts, and special service districts. The clear demarcation of the roles of the general purpose and limited purpose local governments (school districts and special service districts) is unusual.

Structure of Government

Although local governments are subordinate to the state governments, the nature of the relationship between state and local governments varies from state to state. In some states (for example, New Hampshire), local governments play the dominant role in terms of expenditure and revenue assignment, whereas in others (for example, Hawaii), they play a minor role.

In addition, the relationship among local governments varies from state to state. In some states (for example, Massachusetts), municipalities are the dominant form of local government, while in others (for example, Maryland), counties are more significant.

The federalist system in the United States today bears little relation to that envisioned by the founders of the country more than 200 years ago. The Constitution of the United States, ratified in 1787, established the legitimate spheres of the federal and state governments. Nevertheless, the Constitution, reflecting the conflict between those in favor of stronger federal rights and those in favor of stronger state rights, intentionally leaves unclear many issues regarding the assignment of roles and responsibilities among governments. As a result, over the years, the role of the federal, state, and local governments has evolved in response to changing conditions.

In this century, the government sector, including federal, state, and local governments, has expanded. One dominant change in the federalist system stands out. This is the growth in importance of the federal and state governments as the source of funds for public expenditures, with the corresponding decline in the importance of local governments. The federal government has over time expanded its role in many areas that had traditionally been the responsibility of the state and local governments. This growth accelerated during the 1960s with the introduction of the Great Society programs, which expanded income transfers to the poor and to the elderly. State governments have similarly expanded their role in areas that had traditionally been the responsibility of the local governments.

Corresponding to this evolution in the federalist system, there has been a growth in the level of intergovernmental grants (generally categorical or special purpose grants) from higher to lower levels of government. Although the federal government assumed increased financial responsibility for government programs, it did not directly spend all of this money. Instead, it transferred considerable funds to the state and local governments, allowing them to retain administrative control over their traditional programs. A similar evolution has occurred between state and local governments, with state governments transferring money to local governments for education and other purposes.

Federal intergovernmental grants grew most rapidly at a time when the federal government was in a strong fiscal position relative to the state and local governments. Persuasive arguments were offered that intergovernmental grants would produce a more efficient and equitable government system. But the vertical fiscal imbalance between the federal and lower levels of government no longer exists, as a result of the weakening of the federal government’s budgetary position during the 1980s. This weakening has led to cutbacks in federal aid programs and responsibilities.

In contrast to other industrial countries, the United States has no general purpose grants to the states aimed at achieving horizontal equalization. The various categorical grants to the states, although containing equalization factors in their formulas, primarily are used by the federal government to ensure minimum standards. These categorical grants impose federal mandates on states receiving federal assistance, and today the states want the federal government to limit unfunded mandates; that is, spending requirements imposed by the federal government with only partial federal funding, if any.

Administrative Structure

Tax Administration

The United States has a decentralized tax administration with each federal, state, and local government having its own tax administration to collect the taxes it imposes. This decentralization gives each government maximum fiscal independence and control over the base and rates of its taxes. This independence, however, results in higher compliance costs for taxpayers and higher administrative costs for the tax authorities.

Most individuals and businesses file both federal and state income tax returns. They first complete their federal income tax returns before beginning their state return. The burden in filling out their state returns depends largely on the degree of conformity between the state and federal income tax laws. There can be considerable horizontal tax overlapping when an individual lives in one jurisdiction and works or earns income in another, or when an individual moves from one jurisdiction to another. This overlapping is alleviated by one jurisdiction allowing a credit for taxes paid to another. Businesses that operate in more than one state must allocate and apportion the interstate income among the states. The most common apportionment formula is a three-factor formula of sales, property, and payroll with each factor equally weighted. But some states double-weight sales, use only two factors, or use only sales to apportion income. As a result, the same income can be taxed in more than one state, and some income may not be apportioned to any state and thus escape taxation at the state level. A strong case can be made for states using a single, uniform formula for apportioning business income; however, the federal government has no power to enforce this uniformity.

Income tax administration is coordinated between the federal government and each of the 50 states (and the District of Columbia) through agreements to exchange information. This permits states, for example, to follow up on taxpayers who file a federal income tax return but not a state tax return. Also, the state income tax returns of many states ask whether the taxpayer had been audited or had filed an amended federal return.

In 1972, Congress enacted a provision that would have permitted states to elect to have the federal Internal Revenue Service collect the state income tax. A state could piggyback its tax only if the state taxable income conformed to federal taxable income with a few adjustments. States would have been able to set their own tax rates. No state ever elected to piggyback its tax, and Congress repealed the provision in 1990. Among the reasons no state elected piggybacking is the high degree of conformity required under the federal law, the fact that state revenues would change whenever the federal tax base is changed, the states’ unwillingness to rely on federal auditing and enforcement, and the loss of state jobs.

Budget Formulation and Implementation

The federal fiscal year runs from October 1 to September 30, with a specific timetable for completing each part of the budget process. This timetable is not always adhered to, and at times the federal government has entered the new fiscal year without a budget in place.

State budgets operate generally on a July 1 to June 30 fiscal year and an annual basis. Unlike the federal government, states cannot generally submit a budget that will be balanced by the issuance of debt. Also unlike the federal government, state governments separate their budgets into a current (or operating) budget and a capital budget. The operating budget refers to expenditures and revenues for the current year. Operating expenditures include general expenditures for all functions, some utilities expenditures, pension contributions, and payments for debt service. Operating revenue include taxes, fees, intergovernmental aid, and interest on investments. The capital budget refers to expenditures and revenues for long-term capital projects, such as the construction of schools and highways. Capital projects are typically financed by long-term borrowing.

Stringency of the balanced-budget requirement varies from state to state. There are four restrictions that generally apply: the governor must present a balanced current budget, the legislature must pass a balanced budget, the governor must sign a balanced budget, and the state cannot roll over a deficit into the next fiscal year. Most typically, states must satisfy all four requirements, although states practice virtually every other combination. Most states face some requirement to either submit or sign a balanced budget, but some states are not required to realize a balanced budget at year-end, thereby allowing them to carry over an operating deficit into the next fiscal year.1 This gives states more budget flexibility in that they need not act immediately to bring their budgets into balance if expenditures exceed or revenues fall short of expectations. The disadvantage, however, is that states may not address their budget problems immediately and compound fiscal woes by pushing off deficits into the future. Regardless of the specific statutory or constitutional rules that apply to state governments, the municipal bond market ultimately imposes discipline on state budgets.

To avert cash-flow problems under normal budgetary conditions, some state governments may issue short-term debt. But states may create fiscal dilemmas if they issue large volumes of short-term debt and carry this debt over into subsequent years to hide persistent deficits. This practice, also used by local governments, led New York City to the brink of default in 1975.2

States may face many statutory and constitutional limitations on their taxing and spending powers, which complicate the budget process. The most common restriction is to limit the growth of revenues or expenditures to the growth of state personal income. Several states limit growth to the sum of the inflation rate and the growth of population, or to fixed percentage increases. State governments in turn limit local governments, typically by imposing a limit on property tax rates, although some states also limit property tax revenues. Evidence suggests that these limitations have not been very effective in constraining state governments, although they have been more effective in constraining local governments.3

Current Arrangements

Expenditure Assignment

The state and local governments have traditionally been responsible for the provision of basic government goods and services, primarily elementary and secondary education, and police and fire services at the local level, and transportation, public works, public welfare, and higher education at the state level. The federal government has traditionally been responsible for providing national defense and public welfare. Today, however, the state governments have acquired a much more important role in funding public education, even though the provision of these services still remains largely in local hands. The federal government has acquired a much more important role in funding most spheres of public activity, especially public welfare and public works, although again, with the exception of income transfers to the elderly, the provision of these services remains largely in state hands. There is thus considerable expenditure overlapping between the different levels of government on virtually all public activities.

Total government expenditures in 1990 were 40.0 percent of gross domestic product (GDP).4 Federal government expenditures (including intergovernmental grants) were 25.1 percent of GDP, state expenditures (including intergovernmental grants) were 10.3 percent of GDP, and local expenditures were 10.5 percent of GDP (Table 1). Over time, the relative importance of the different levels of government and the mix of spending and revenues at each level has changed (Tables 1, 2, and 3).

Table 1.United States: Total Government Expenditures, Selected Years(In percent of GDP)
All GovernmentsFederalStateLocalU.S. GDP
Total1TotalDirect2IntergovernmentalTotalDirect3IntergovernmentalTotalDirect(In billions of U.S. dollars)
Year(1)(2)(3)(4)(5)(6)(7)(8)(9)(10)
196230.619.718.41.36.34.41.97.97.8575.8
196731.420.418.51.87.24.82.38.18.1819.8
197032.720.518.22.38.45.52.89.19.01,017.1
197535.021.418.33.19.96.73.310.210.11,599.1
198035.022.519.23.39.46.33.19.59.42,742.1
198539.025.522.82.69.66.63.09.69.54,053.6
199040.025.122.52.710.37.23.210.510.45,542.9
Source: Advisory Commission on Intergovernmental Relations (1994c).

Excludes duplicative intergovernmental transactions; it is less than the sum of the federal, state, and local totals in columns 2, 5, and 8.

Includes Social Security and Medicare insurance, employee retirement, railroad retirement, veterans’ life insurance, and unemployment compensation.

Includes utility expenditure, employee retirement, unemployment compensation, workers’ compensation, and other insurance trust expenditure.

Source: Advisory Commission on Intergovernmental Relations (1994c).

Excludes duplicative intergovernmental transactions; it is less than the sum of the federal, state, and local totals in columns 2, 5, and 8.

Includes Social Security and Medicare insurance, employee retirement, railroad retirement, veterans’ life insurance, and unemployment compensation.

Includes utility expenditure, employee retirement, unemployment compensation, workers’ compensation, and other insurance trust expenditure.

Table 2.United States: Total Government Revenues, Selected Years(In percent of GDP)
AllStateLocalU.S. GDP
GovernmentsFederalIntergovernmentalIntergovernmentalOwn(In billions of
Total1TotalTotalFederalLocalsource2TotalFederalState3source2U.S. dollars)
Year(1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)
196229.218.56.51.20.15.27.50.11.95.5575.8
196730.819.77.51.70.15.77.90.22.23.4819.8
197032.820.28.71.90.16.88.80.32.65.91,017.1
197532.519.09.82.30.17.510.00.73.26.11,599.1
198034.020.610.12.30.17.89.40.83.05.72,742.1
198535.019.910.82.10.18.69.90.52.96.54,053.6
199036.920.811.42.10.19.110.50.33.17.05,542.9
Source: Advisory Commission on Intergovernmental Relations (1994c).

Excludes duplicative intergovernmental transactions; it is less than the sum of the federal, state, and local totals in columns 2, 3, and 7.

Includes taxes, user charges, miscellaneous general revenue, utility revenue, liquor store revenue, and social insurance revenue.

Includes substantial but unknown amounts of federal grants to states that are “passed through” by the states to local governments.

Source: Advisory Commission on Intergovernmental Relations (1994c).

Excludes duplicative intergovernmental transactions; it is less than the sum of the federal, state, and local totals in columns 2, 3, and 7.

Includes taxes, user charges, miscellaneous general revenue, utility revenue, liquor store revenue, and social insurance revenue.

Includes substantial but unknown amounts of federal grants to states that are “passed through” by the states to local governments.

Table 3.United States: Federal, State, and Local Revenues and Expenditures(In percent of GDP unless otherwise noted)
197019801990
Total federal revenues (in percent)20.220.620.8
General16.115.214.1
Intergovernmental0.10.1
General from own sources16.115.214.1
Taxes14.412.811.4
Individual income8.98.98.4
Corporation income3.22.41.7
Sales, gross receipts, and customs duties1.81.21.0
Other0.40.40.3
Charges and miscellaneous1.72.42.7
Insurance trust4.15.36.7
Total federal expenditures (in percent)20.522.525.1
General16.416.318.1
Intergovernmental2.33.32.7
Direct general14.113.015.4
National defense and international relations8.35.56.2
Interest on general debt1.42.23.4
Other4.16.57.1
Insurance trust4.16.27.1
Total state and local revenues (in percent)14.816.518.6
General12.913.915.3
Intergovernmental from federal2.13.02.5
Own source10.710.912.9
Taxes8.58.19.0
Property3.32.52.8
Sales and gross receipts3.02.93.2
Individual income1.11.51.9
Corporation income0.40.50.4
Other0.80.70.7
Charges and miscellaneous2.22.83.8
Utilities and liquor stores0.80.91.1
Insurance trust1.11.62.2
Total state and local expenditures (in percent)14.615.817.6
General12.913.515.1
Education5.24.95.2
Public welfare1.41.72.0
Hospitals0.80.90.9
Health0.20.30.4
Highways1.61.21.1
Police protection0.40.50.6
Corrections0.20.20.4
Sewerage and solid waste0.30.50.5
Interest on general debt0.40.50.9
Other2.42.73.0
Utilities and liquor stores0.91.31.4
Insurance trust0.71.11.1

The largest components of federal expenditures are for insurance trust programs (largely Social Security and Medicare), national defense, interest on government debt, and intergovernmental aid. In recent years, Social Security and Medicare and interest on government debt have increased dramatically as a share of federal spending, while national defense and intergovernmental aid have declined. The largest components of state and local expenditures are for education and public welfare. State and local governments have increased spending most dramatically on health, prisons, and interest on debt in recent years.5

Tax Assignment

The U.S. Constitution grants the federal and state governments independent taxing powers, while local governments derive their powers to tax from the state governments. Each government imposes its own taxes. There are no shared taxes, although more than one government may exploit the major revenue sources.

Total government revenues in 1990 were 36.9 percent of GDP. Federal government revenues were 20.8 percent of GDP, state revenues (including intergovernmental grants) were 11.4 percent of GDP, and local revenues (including intergovernmental grants) were 10.5 percent of GDP (see Table 2). As with expenditures, over time, the relative importance of the different levels of government and the mix of revenues at each level has changed (see Tables 1, 2, and 3).

At the federal level, the personal income tax and payroll taxes have become the most important sources of tax revenue while the corporate income tax and selective sales taxes have diminished in importance in recent years, reflecting a combination of political and economic factors.6 Unlike most developed countries, there is no broad-based consumption tax at the federal level.7

At the state level, the general sales tax has traditionally been the most important source of tax revenue. The personal income tax has, however, now essentially reached parity with the general sales tax. Similar to the federal level, the shares of corporate income tax and selective sales taxes have diminished in recent years.8

States exhibit considerable variation in their tax structure. Most states impose their own personal and corporate income taxes, sales taxes, and wealth transfer taxes. Broad-based state personal income taxes are imposed by 43 states, while corporate income taxes are imposed by 44 states. Michigan replaced its corporate income tax with a value-added tax (which differs from the value-added taxes in place elsewhere in that it is based on the additive method).9 General sales taxes are imposed by 45 states. Alaska and New Hampshire impose no broad-based personal income taxes or general sales taxes.

At the local level, the property tax remains the predominant form of tax revenue, though it has diminished in importance in recent years. Frequently, more than one local jurisdiction levies a property tax, with each local jurisdiction levying its own rate with respect to its definition of the property tax base. In some states, local governments impose sales and income taxes.

Intergovernmental Grants

Intergovernmental grants create a complex web of transfers from one level of government to another.10 State and local governments are heavily dependent on transfers from the federal government to meet their financial needs. Federal grants as a percent of state and local expenditures increased greatly in the 1960s and early 1970s.11 Federal government grants peaked in 1980 when these funds accounted for 27.6 percent of state and local general expenditures. Federal grants then declined as a proportion of expenditures, reaching a low of 16.7 percent in 1989, but have risen more recently, reflecting an increase in income transfers (Table 4). An increasingly large share of federal grant outlays are direct payments to individuals through income-transfer programs, administered by state governments.

Table 4.United States: Grants and General Expenditures
YearFederal Grants as a Percentage of State and Local General ExpendituresState Grants as a Percentage of Local General Expenditures
197219.934.3
197322.835.5
197421.536.6
197521.535.9
197626.935.8
197727.036.1
197826.736.3
197926.137.4
198027.637.5
198123.237.7
198219.737.1
198319.035.7
198419.635.5
198519.436.5
198619.136.3
198717.035.7
198816.935.5
198916.735.9
199017.634.7
199117.634.4

A large proportion of the federal grants are passed through from state governments to local governments. In addition, state governments provide their own grants to local governments. Local governments are heavily dependent on this aid. Total state grants to local governments (including federal pass-through grants) were 34.4 percent of local expenditures in 1991 (see Table 4).12

Grant programs in the United States are either nonconditional or conditional. The main nonconditional program was revenue sharing, which was based on equalization principles. General revenue sharing was provided by the federal government to local governments from 1972 to 1986 and to state governments from 1972 to 1981.13 This money was distributed by statutory formula with few restrictions on its use.14 State governments still provide some nonconditional support to local governments.

There are two types of conditional grants. Block grants apply to broad categories of related functions and impose few restrictions on how states and localities allocate funds to activities within the block. There are block grants for health, social services, and other areas of expenditures.

Categorical grants provide money for a specific program, and several major types of categorical grant programs are used at the federal level. Formula-based grants distribute money to states and localities according to legislatively or administratively defined criteria. These criteria include factors that measure the needs of the community, its capacity to provide public services, the cost of providing public services, and the tax effort the community is already making to provide public services. These formulas vary from the most simple to very complicated but are typically related to population and per capita income of the community. The simplest formula might provide a fixed amount to each grant recipient regardless of the costs of providing that service. More typically, formulas provide amounts related to the costs of providing the service so the formula would have a variable amount (or a fixed and variable amount) related to the total population in the grant recipient’s jurisdiction. For special purpose grants for education, the formula might vary with school enrollment; for prisons, the formula might vary with prison population, and so on.15

Formula grants include both open-ended, matching grants, and closed-end, matching and nonmatching grants. Medicaid (medical assistance for the poor) is the largest open-ended, matching program. The matching rate varies across states in inverse fashion to per capita income with the federal share ranging from 50 percent to roughly 80 percent.16

Project grants do not distribute money in a general manner. Governments solicit applications for these grants and award the funds selectively. These grants are closed-end and may or may not have matching requirements. There are also mixed formula and project grants, which are discretionary grants that are constrained by a formula.

Approximately half of the categorical grants require matching funds from the state and local governments, although the number of programs requiring matching funds has tended to decline in recent years. The state matching rate is usually quite low, covering far less than half of expenditures for most matching programs.

In 1993, the federal government had 593 grant programs—15 block grants and 578 categorical grants. Even though the federal government has made efforts, particularly in the early 1980s, to decrease the number of grant programs, these programs continue to proliferate, rising from 404 grant programs in 1984 to 593 programs in 1993.

In 1993, 1.1 percent of federal grant outlays were for general purpose grants (payments to Puerto Rico and the District of Columbia), 10.6 percent for broad-based grants (mostly block grants), and 88.3 percent for categorical grants. In 1993, project grants were 72.5 percent of federal categorical grant outlays, the highest percentage since 1975.17

Federal grant programs encompass the full range of government activities. The largest number of grants are for education, social services, health, transportation, pollution control, and regional development. In terms of expenditures, the greatest growth in recent decades has been for health, rising from 9.0 percent of federal grant expenditures in 1966 to 41.0 percent in 1994. This increase largely reflected the growth of Medicaid, which began in 1966 with $0.8 billion of expenditures (6.0 percent of expenditures) and reached $82.0 billion in 1994 (39.0 percent of expenditures). The increase in Medicaid spending has resulted from rapid increases in health care costs and in the number of people served by Medicaid, new services mandated by the federal government, and the discovery of strategies by states to enhance the federal contribution. Income support dropped from 27.8 percent to 24.5 percent of outlays over this period, while transportation dropped from 31.6 percent to 11.2 percent and education dropped from 20.0 percent to 15.5 percent.18

The distribution of federal grants has changed significantly over time among states. On a per capita basis, states that at one time were the largest recipients of aid have fallen relative to other states. The link between federal aid and state fiscal capacity—the potential ability to raise revenue relative to the cost of service—is weak. In the United States, however, intrastate disparities in fiscal capacity tend to be even larger than interstate disparities. Comparing counties within a state, federal aid does appear to reduce disparities in fiscal capacity.19

Although the state governments employ the same types of grants, their number and function are more limited. Well over half of state grant outlays to local governments are formula-based grants for public elementary and secondary education. The formulas on which this aid is based are usually related to local tax effort and expenditure needs and are intended to equalize spending on education across school districts. The states make only limited use of project grants in addition to general budgetary support. In addition to education, state governments provide funds for public welfare and other public services.

Considerable research has examined the effect of intergovernmental grants on the nature of state and local fiscal decisions.20 The main conclusion of econometric research is that grants exert a powerful influence on both the level and composition of spending by recipient governments, emphasizing the importance of incorporating intergovernmental grants into an analysis of fiscal decision making.21 In addition, this research has found that matching grants stimulate more spending than nonmatching grants, consistent with the predictions of the positive theory of grant response. These empirical findings suggest the importance of intergovernmental grants in determining the level and mix of public goods and services in the United States.

Tax Expenditures

Two features of the federal tax code are similar to grant programs, even though they do not involve direct transfers of funds to state and local governments. The federal government allows taxpayers who itemize personal expenses on their federal income tax returns to deduct the state and local income taxes and property taxes from gross income in computing federal income tax liabilities. Deductibility lowers the cost of these taxes for taxpayers who itemize. In effect, these taxpayers do not pay federal taxes on income used to pay these taxes. Deductibility allows state and local governments to shift part of the burden of these taxes to the federal government and thereby to make this deductibility equivalent to an open-ended, matching grant to state and local governments. Deductibility is an inefficient way to subsidize lower levels of government. The same support for state or local government spending could be achieved through direct transfers at lower cost to the federal treasury. Deductibility also reduces the progressivity of the federal tax code. In 1986, the federal government eliminated the deductibility of state and local sales taxes and contemplated eliminating all deductible taxes. The federal tax expenditure from this deductibility was estimated at $38.1 billion in 1994, representing one of the largest tax expenditures in the federal tax code. In some cases, states allow deductibility of federal income taxes, as well.

Interest on state and local debt is generally exempt from federal income taxes. The tax exempt feature of this debt allows state and local governments to issue it at a lower interest rate than prevails in the market because its return must only be competitive with the after-tax return to taxable debt. This exemption also functions like an open-ended, matching grant to state and local governments. This exemption is criticized as inefficient because it provides a higher return than is necessary for all but the marginal taxpayer and as inequitable in that the benefits largely accrue to higher-income taxpayers. In the early 1980s, state governments greatly expanded the use of municipal debt for private purposes. Encouraged by the tax exempt status of municipal debt, state governments borrow to subsidize private investments for the purpose of promoting economic development. This borrowing generally takes the form of revenue bonds, which are backed only by revenues from the project they are intended to finance. The rapid increase in this borrowing led Congress in 1986 to enact a cap on the amount of private purpose bonds each state can issue. The tax expenditure from the exemption of interest on municipal debt in 1994 was $12.0 billion for public purposes and $7.6 billion for private purposes.

Borrowing

The federal government is not required to run a balanced budget, but may issue debt to finance its deficit.22 In 1991, the federal government’s debt was $3,683.1 billion, equal to 65.0 percent of GDP.23

In 1991, aggregate state and local debt was $915.8 billion, equivalent to 16.2 percent of GDP. This figure has increased in recent decades, rising from 14.3 percent of GDP in 1970. Most of the growth has come in state government debt, which rose from 4.2 percent to 6.1 percent of GDP over this period.24 State and local governments, which must generally have a balanced operating budget, primarily borrow to finance capital projects, such as public works and schools. They also borrow to subsidize private capital investments and to ease short-term cash flow problems. State and local borrowing is generally governed by constitutional and statutory provisions that vary across states and localities. The largest share of state and local government borrowing has typically financed the construction of highways, followed by education facilities, water and sewerage facilities, and other utilities. In recent decades, borrowing for highways and education has declined while that for utilities has risen. State and local governments also borrow to meet short-term cash flow needs. Since revenues and expenditures do not always match, governments borrow to cover short-term revenue shortfalls. Some governments have abused this privilege by using short-term borrowing to conceal deficits in their operating budgets, although requiring governments to adhere to generally accepted accounting practices constrains this activity. States also borrow to subsidize private industry. However, the 1986 Tax Reform Act’s limitations on the use of tax-exempt borrowing for private purposes has dampened some of this activity.

In recent decades, large city governments in the United States, particularly in the East and Midwest, have encountered serious budget problems. As middle-income residents and businesses left for the suburbs, tax bases declined rapidly and needs for social welfare and other income-related public services rose rapidly. Several cities have used debt to buy time, but have in the process come close to default or bankruptcy (for example, Cleveland, New York, and Philadelphia). These problems have led to useful mechanisms to avoid such crises in the future, in particular, the development of stricter accounting standards for governments. Hard-pressed cities have looked to the state governments (and secondarily to the federal government) for assistance and in the process have become heavily dependent on state (and federal) funds.25

State and local governments are, in principle, free to borrow without federal government interference, and, in fact, the federal government subsidizes state and local borrowing by exempting the interest on state and local bonds from federal income taxation. In the case of state and local borrowing to finance private activities, such as home mortgages, student loans, airports, and water facilities, the exemption from income tax is limited to “qualified private activity bonds.”

State and local borrowing also is limited, in part, by the requirements that state and local governments run balanced operating budgets and by the stricter accounting standards mentioned above. An even more important factor, however, is that the federal government does not guarantee state and local bonds. These bonds must be floated on the private capital market and meet the market test for soundness. More-over, investors in state and local bonds rely on private bond rating agencies that grade the quality of bonds issued by the various state and local governments which, in turn, are quite sensitive to the risk their bonds will be downgraded as this affects borrowing costs.

Implications

Macroeconomic Management

Economic slowdowns cause budget problems for government by reducing revenues and increasing some expenditures above expected levels. During slowdowns, government spending rises above expected levels as people lose their jobs or face reduced workweeks, retire, and become eligible for unemployment compensation, welfare, pensions, and other income-transfer programs. The federal and state governments share the impact of these cyclical changes because they share funding responsibilities for the main income-transfer programs. Although the states administer Aid to Families with Dependent Children and Medicaid, the largest income-transfer programs available to the nonelderly, the federal government pays more than half of the cost of these programs. This raises the issue of what is the appropriate role of the federal and state governments in providing income insurance. The federal government has been seen as the principal provider of this insurance because it has greater capacity for countercyclical spending and a broader tax base.26

The sensitivity of revenues to change in the level of economic output or income is measured by the income elasticity of revenues. Corporate and personal income taxes are generally regarded as having the greatest income elasticities, followed by the general sales tax, wealth taxes, and selective sales taxes. Since the federal government derives a large part of its revenue from income taxes, federal tax revenues tend to be income elastic. Since state governments derive a large part of their tax revenues from a mix of income taxes and the general sales tax, their tax revenues tend to be elastic but not as much as federal taxes. The U.S. Treasury estimated the weighted-average income elasticity of own source federal revenues as 1.14, state revenues as 1.10, and local revenues as 0.97, in 1984.27

This dependence on income-elastic taxes exerts a destabilizing influence on the budget because revenues grow more rapidly than income in expansions and revenues shrink more rapidly than income in recessions.28 In recent decades, the federal government and state governments have relied increasingly on income and payroll taxes, making their tax revenues more sensitive to economic fluctuations.

Local governments, in contrast, for own source revenues rely primarily on property taxes, which are among the least elastic taxes. This exerts a stabilizing influence on local budgets during economic downturns, unless, as may sometimes be the case, an economic downturn coincides with a crash in the real estate market. In addition, with the exception of only a few local jurisdictions, local governments do not bear any direct responsibility for Aid to Families with Dependent Children and Medicaid, and hence do not face the same spending pressures in a downturn. Nevertheless, in a prolonged downturn, even the property tax may exhibit some income elasticity as nonpayment of taxes increases and property values are lowered to reflect the decline in economic activity, resulting in a drop in tax revenues (it is not always possible for local governments to raise tax rates to compensate for a decline in the base). In addition, in a growing economy, the inelasticity of the local government tax base results in a tax base that may grow relatively slowly compared with the income tax base, causing long-term problems for local governments.

Since the federal government can run a budget deficit, its budget tends to exert a countercyclical influence on economic activity. When economic activity slows, the budget deficit widens, moderating a downturn. When economic activity increases rapidly, the budget deficit shrinks, moderating the stimulus. In principle, federal grants (as distinct from entitlement programs) could be used for explicitly countercyclical purposes, increasing during downturns and decreasing during upturns. There does not, however, appear to be any conscious policy of countercyclicality built into federal grant programs. In addition, the lags between recognition of an economic downturn, approval of additional spending, and actual spending may be too long for “public works” spending to be an effective countercyclical policy. Nevertheless, since a large share of grants are for income-transfer programs, such as Medicaid, these grants would tend to exert a countercyclical influence on the economy. But since the income-transfer programs require matching funds from state governments, this countercyclicality would not necessarily lead to a marked improvement in state and local budget problems. Other potentially countercyclical elements in federal grant policy have diminished in recent years with the fiscal retrenchment taking place at the federal level.

Since state and local governments generally cannot run a budget deficit on the current budget, their budgets have both countercyclical and procyclical elements. When economic downturns occur, state and local governments must move rapidly to eliminate any emerging deficit caused by falling revenues and rising expenditures. There are a variety of ways to finance a deficit.29

One way is to draw down reserve funds. Many states have Rainy Day Funds in which they hold surplus revenues for times of budgetary stress. A generally accepted rule of thumb in state government budgeting is that reserve be equal to approximately 5 percent of the current budget. Cash reserves can be used to conduct a countercyclical fiscal policy. As revenues fall in a downturn, previously accumulated cash reserves can be used to cushion the impact of this shortfall. As revenues rise in an upturn, surpluses can be allowed to accumulate. In recent years, the arrangements for Rainy Day Funds have become more formalized, even though most states have not met their reserve goals.30 As a practical matter, it is difficult for state governments to maintain reserves, since there are always pressing needs and political pressure for government spending. In principle, reserves could play an important countercyclical role, but in practice, they have not been important in recent years.

Large deficits, however, require spending and revenue adjustments that can either be short or long term in nature. On the spending side, the main problem is that states have little flexibility for cutting their budgets in the short term. A large proportion of state spending goes for goods and services, including contractual wages and salaries, leaving state governments with little room for discretionary spending cuts. Since state governments provide sizable aid to local governments, this is one area in which they may have some flexibility in cutting spending, although, in the case of education, the largest aid component, they may face restrictions on short-term cuts. In addition, reducing aid to local governments may help a state government avert a budget problem, but it ends up pushing the problem onto local governments. One tactic is to shift expenditures—such as the last paycheck of the fiscal year to state government employees, to vendors, or to local governments—into the next fiscal year. However, this is at best a stop-gap strategy because the additional revenues must be raised in the following year. States may also defer or eliminate capital expenditures, although delaying needed projects may raise their ultimate cost. Other methods include undermaintaining the infrastructure and underfunding the contribution to the employees’ pension system or borrowing from it. But these tactics only thrust the problems onto future taxpayers.

On the revenue side, a large deficit may require governments to take short-term measures, such as accelerating the collection of taxes or raising taxes or other revenues. State governments can accelerate tax collection by reducing the interval for collection, creating a onetime revenue gain. State governments may also increase tax revenues by raising the rate of existing taxes, by broadening the base to which a tax applies, or by instituting a new source of tax revenues altogether. Unless the tax change is reflected in withholding or current payments, the change will not, however, increase revenues in the current fiscal year. Another way to raise revenues is by charging or increasing user fees for services.

The extent to which state budget management results in a countercyclical or procyclical influence depends in part on whether the stimulative effects of additional spending outweigh the depressing effects of higher taxes and charges required to balance the budget. In the most recent recession, state budgets were viewed as exerting a markedly more procyclical stance than in the past, reflecting the many pressures placed upon state governments these days.

While short-term state budget problems may largely reflect cyclical forces in the economy, to the extent that these problems represent longer-term structural budget problems, they require states to supplement short-term measures with more fundamental reforms of expenditures and revenues. These reforms may take the form of cuts in the scope or extent of expenditure programs, greater efficiency in the provision of public services, expansion of the tax base, increases in tax rates, or introduction of a new tax. States faced with persistent revenue shortfalls have taken a variety of adjustment measures, depending on the political and economic situation. States where voters are already discontented with the high level of taxes may have to rely on expenditure cuts. Elsewhere, state voters may find tax hikes more palatable.

Structural Reform

In recent decades, an important source of pressure on state governments has come from local governments to assume responsibilities for certain programs and to increase intergovernmental aid. The pressures stem primarily from demands of the poorer communities for redistribution from wealthier communities.

Public education is one area where most state governments are under pressure to increase their funding responsibilities because of inequalities in spending levels across communities within a state. Public elementary and secondary education was once largely the responsibility of local governments, with most funding coming from the local property tax. Since the local property tax is the main source of tax revenue for localities, the variation in wealth across communities within a state, reflected in property values, leads to similar variation in local government ability to fund local public services. State governments have reduced this variation through intergovernmental grants to the local governments for funding public elementary and secondary education and other public services. Nevertheless, these efforts have been inadequate to satisfy critics of the system of funding public education.

Since the 1971 Serrano vs. Priest decision in California, under which the state supreme court ordered the state to devise a grant program to equalize per pupil spending across California school districts, courts in the majority of states have ordered state governments to reform their public education financing system, leading to far-reaching changes in state tax systems to finance the additional responsibilities. In recent decades, the states have assumed a more important role in this funding. Since the 1970s, state governments have financed a larger share of this education than local governments. Nevertheless, 25 years after Serrano, there are still many inequalities in public education financing and the court cases continue. Ultimately, state governments may have to assume most of the role of funding elementary and secondary education, requiring stronger taxing powers.

Strengthening the taxing powers of the state government generally entails reforming both the general sales tax and the personal income tax.31 The main problem with the general sales tax is that it often taxes business services while exempting a significant fraction of personal consumption. In particular, most general sales taxes do not tax consumer services in any comprehensive way and efforts on the part of state governments to extend the sales tax to services have at times met with significant opposition, although some extension to services has occurred in recent years. Despite the low overall reliance on consumption taxes in the United States relative to other developed countries,32 the personal income tax remains the most promising prospect for state governments to expand their taxing powers. This tax has grown rapidly in recent decades as a share of state government revenues and is best suited to meet the demands for increased redistribution between communities in a state.

There have also been important structural changes in the intergovernmental grants system. In the early 1980s, the Reagan administration suggested major changes in the system of distributing federal grant money. It proposed eliminating the general revenue-sharing program to the state governments and consolidating many smaller categorical grants into larger block grants, both of which were enacted. The administration’s more dramatic proposals were to shift responsibility for the major health and public assistance programs. It proposed that the federal government assume all responsibility for Medicaid and return almost all responsibility for Aid to Families with Dependent Children and food stamps (in-kind food aid to the poor) to the state and local governments. These proposals were not enacted, although given the growth of Medicaid spending, the states may wish that they had disposed of any responsibility for this program.

In 1986, the Reagan administration eliminated local revenue sharing and the deductibility of sales taxes and limited the use of tax exempt municipal bonds. Since then, there have been no major shifts in the federalist system, although, both Presidents Bush and Clinton have proposed various changes.

The year 1996 has proven to be a watershed for U.S. intergovernmental fiscal relations. In 1996, the Republican-controlled Congress enacted legislation to end the federal entitlement for Aid to Families with Dependent Children. The bill replaces this program with a block grant to states and allows them to set their own eligibility standards.

The amount a state can receive depends on the amount it was receiving under Aid to Families with Dependent Children. The bill restricts eligibility for individuals who remain unemployed, requiring recipients to find a job within two years of first receiving aid. It also restricts lifetime benefits to five years of aid. This change will have major ramifications for state and local governments. The main change is a greatly increased role for state governments. This strategy is designed to shift budgetary pressures from the federal government to the state and local governments and to give state and local governments more discretion in how they design and administer welfare programs. State and local governments will feel budgetary pressures most acutely in any future recessions when the need for entitlements grows rapidly. The likely result is that state spending on entitlements will decline in the face of diminished resources and an increase in the effective “price” of these entitlements with the loss of the matching grant.

Still remaining on the Republican agenda are legislation to amend the Constitution to require a balanced budget, and to replace the federal income tax with a flat tax or consumption-based tax.33 If the federal government adopts a balanced budget amendment, this could also lead to cuts in intergovernmental aid, adding further stress on the state and local governments.

Recent proposals for federal tax reform could also have a significant effect on state and local finances. Several of these proposals would eliminate any remaining deductibility of state and local taxes under the federal income tax. Adoption by the federal government of any proposal for a broad-based consumption tax to replace the federal income tax likely would force states to abandon their corporate income taxes inasmuch as these taxes conform to the federal tax base. With repeal of the federal tax, the state tax bases would diverge, imposing much higher compliance costs on companies that operate in many states. Taken together, federal changes in intergovernmental grant policy, budget policy, and tax policy could imply radical changes in the nature of fiscal federalism in the United States in years ahead.

The authors wish to thank Ehtisham Ahmad, Robert Ebel, Richard Hemming, Teresa Ter-Minassian, and the IMF’s Western Hemisphere Department for helpful comments.

Inman(1983).

This total excludes duplicative intergovernmental transactions; thus, it is less than the sum of the federal, state, and local totals.

State and local governments are typically aggregated because the breakdown between state and local governments varies from state to state. Thus, the precise breakdown between state and local governments is less meaningful than the aggregate. See Advisory Commission on Intergovernmental Relations (1994c).

Increased demands for redistribution through the tax code and the need for a buoyant source of revenues has led to the increase in personal income taxes, while payroll taxes have risen to support increased Social Security and Medicare responsibilities.

Under the additive method the tax base is determined by adding (1) wages and (2) profits before taxes and debt service with certain adjustments.

See Department of the Treasury, Office of State and Local Finance (1985) for a comprehensive discussion of the intergovernmental grants system in the United States.

Federal grants are best expressed as a share of combined state and local outlays because an unknown amount of federal grants are passed on from state to local governments and the breakdown of responsibilities between state and local governments varies from state to state.

Federal budgetary problems led to the erosion of support for this program, leading to its termination.

The revenue-sharing formula included a mixture of factors reflecting expenditure needs and fiscal capacity. In the case of local governments, there was a “tiering” of the allocation process, with funds allocated first to counties and then to local governments within counties, disadvantaging poor jurisdictions in rich countries. See Department of the Treasury, Office of State and Local Finance (1985), pp. 183–93.

Aid to Families with Dependent Children (income support for poor families, generally headed by a single mother) was until 1996 the other large open-ended matching grant program.

Although intergovernmental grants are one mechanism by which the federal and state governments influence the actions of lower levels of government, mandates, particularly by the federal government, are another important mechanism. The receipt of grants may be premised on state and local governments meeting certain federally determined conditions. These mandates may be unfunded requiring state outlays to meet the federal requirements.

There have been proposals for a Constitutional amendment to require a balanced budget. In the spring of 1995, one balanced budget amendment received the required two-thirds vote in the House but failed in the Senate by one vote. It is not clear whether three-fourths of the states would ratify an amendment proposed by the Congress.

In contrast, income-elastic taxes exert a stabilizing effect on economic performance.

Break (1994), pp. 1–5.

References

    Advisory Commission on Intergovernmental Relations1994aCharacteristics of Federal grant-in-Aid Programs to State and Local Governments: Grants Funded FY 1993 (Washington: Advisory Commission on Intergovernmental RelationsJanuary).

    Advisory Commission on Intergovernmental Relations1994bSignificant Features of Fiscal FederalismVol. 1 (Washington: Advisory Commission on Intergovernmental RelationsJune).

    Advisory Commission on Intergovernmental Relations1994cSignificant Features of Fiscal FederalismVol. 2 (Washington: Advisory Commission on Intergovernmental RelationsDecember).

    BreakGeorge F.1994“The Big Four of State-Local Tax Finance: Under Siege in a Changing World,”NTA ForumSpring/Summer, pp. 15.

    CraigSteven G. andRobert P.Inman1982“Federal Aid and Public Education: An Empirical Look at the New Fiscal Federalism,”Review of Economics and StatisticsVol. 64 pp. 54152.

    CraigSteven G. andRobert P.Inman1986“Education, Welfare and the ‘New’ Federalism: State Budgeting in a Federalist Public Economy,”Studies in State and Local Public Financeed. by Harvey S.Rosen (Chicago: University of Chicago Press for the National Bureau of Economic Research).

    Department of Commerce Bureau of the CensusGovernment Financesvarious issues.

    Department of the Treasury Office of State and Local Finance1985Federal-State- Local Fiscal Relations (Washington: U.S. Government Printing Office).

    EcklCorina L.1987State Deficit Management Strategies (Denver: National Conference of State LegislaturesNovember).

    GoldSteven D.1995“Impacts of the Revolution in Federal Policies on State and Local Government,”NTA ForumSummer, pp. 16.

    GramlichEdward M.1977“Intergovernmental Grants: A Review of the Empirical Literature,” in The Political Economy of Fiscal Federalismed. by Wallace E.Oates (Lexington, Massachusetts: Lexington Books).

    GramlichEdward M.1982“An Econometric Examination of the New Federalism,”Brookings Papers on Economic ActivityVol. 2 pp. 32760.

    InmanRobert P.1979“The Fiscal Performance of Local Governments: An Interpretive Review,” in Current Issues in Urban Economicsed. by PeterMieszkowski andMahlonStraszheim (Baltimore: Johns Hopkins University Press).

    InmanRobert P.1983“Anatomy of a Fiscal Crisis,”Business Review: Federal Reserve Bank of PhiladelphiaSeptember/October pp. 1522.

    KenyonDaphne A. andKaren M.Benker1984“Fiscal Discipline: Lessons from the State Experience,”National Tax JournalVol. 37No. 3 pp. 43346.

    LaddHelen F. andJohnYinger1989America’s Ailing Cities (Baltimore: Johns Hopkins University Press1989).

    MessereKen1993Tax Policy in OECD Countries (Amsterdam: IBFD Publications BV).

    National Governors’ Association1994The Fiscal Survey of the States (Washington: National Governors’ AssociationApril).

    OatesWallace E.1972Fiscal Federalism (New York: Harcourt Brace Jovanovich).

    Office of Management and Budget1996Budget of the United States Government: Historical Tables (Washington: Office of Management and Budget).

    PrestonAnne E. andCaseyIchniowski1991“A National Perspective on the Nature and Effects of the Local Property Tax Revolt, 1976–1986,”National Tax JournalVol. 44No. 2 pp. 12345.

    StotskyJanet G.1991“State Fiscal Responses to Federal Government Grants,”Growth and ChangeSummer pp. 1731.

    Other Resources Citing This Publication