19 Developments in Federal-State-Local Fiscal Relations

Yusuke Horiguchi
Published Date:
January 1992
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I the decade of the 1980s, the tide of federalism reform has been running in the direction of attempting to return significant responsibilities from the federal level to the state level of government. Early in the 1980s the U.S. Administration made a number of specific proposals to realign responsibilities between the different levels of government and thereby stem the movement toward increased centralization that had occurred in the preceding decades. Paralleling these attempts to redefine intergovernmental fiscal relations, the Federal Government, particularly in the latter half of the decade, has reduced the real value of transfers to state and local governments.

These changes have been occurring against the background of growing concern in the United States about the adequacy of the stock of infrastructure capital and about the effectiveness of the education system, two areas of economic activity that in varying degrees over time have been the shared responsibility of all levels of government.1 The perceived problems in these areas have been felt by many as, inter alia, potentially hindering the capacity of the U.S. economy to compete internationally. The response of the U.S. Administration in recent years has been to outline a broad strategy for reform in which much of the responsibility for implementing that strategy would rest with the other levels of government.2

This chapter evaluates prospective needs in the areas of infrastructure, capital formation, and education and considers how the responsibility for meeting those needs might be assigned to the different levels of government. Subject to the important caveat that there be no major reform to the manner in which consumers are charged for its use, a case can be made that the current levels of investment in infrastructure and the associated stock of social overhead capital may be lower than desirable. In light of the tightening fiscal circumstances being experienced by many states partly as a result of recent trends in intergovernmental fiscal relations, this deficiency could be exacerbated in the period ahead. As regards education, the conclusion will be that the solution to the problems that exist does not lie in increasing expenditures, although some gains might result from an improved allocation of existing expenditures.

I. Overview of Recent Developments in Federal-State-Local Relations

It is useful to summarize the most notable developments in federal-state-local relations as background to the analysis of infrastructure and education needs.

First, counterbalancing developments in the 1960s, when the War on Poverty and the Great Society programs resulted in a sharp expansion in the role of the Federal Government, the 1970s and 1980s have seen an effort to reverse the flow of power to the Federal Government.

Second, as regards the financial implications of the swings in intergovernmental relations for the other levels of government, federal real grants-in-aid peaked in fiscal year 1978 (Table 1).

Table 1.Federal Outlays for Grants-In-Aid to State and Local Governments(In billions of U.S. dollars)
TotalPayments to IndividualsCapital InvestmentRemainder

In current

In FY 1982

In current

In FY 1982

In current

In FY 1982

In current

In FY 1982

Source: Office of Management and Budget (1990).

Estimates, Office of Management and Budget.

Source: Office of Management and Budget (1990).

Estimates, Office of Management and Budget.

Third, as regards trends in components of grants, those for state and local capital expenditures have been declining rapidly while those for payments to individuals have been rising even as a share of GNP (Table 2).

Table 2.Federal Outlays for Grants-In-Aid to State and Local Governments
TotalPayments to IndividualsCapital InvestmentRemainder


of TFO1

of GNP

of TFO1

of GNP

of TFO1

of GNP

of TFO1

of GNP
Source: Office of Management and Budget (1990).

TFO refers to total federal outlays.

Estimates, Office of Management and Budget.

Source: Office of Management and Budget (1990).

TFO refers to total federal outlays.

Estimates, Office of Management and Budget.

Fourth, the value of tax expenditures to state and local governments arising from the deductibility of many state and local tax payments from federal tax liabilities and the federal tax exemption of interest on state and local bonds has been declining, reflecting both the legislative elimination of some tax expenditures and the incidental effect of reduced federal marginal tax rates.

Fifth, as regards its impact on decisions at the state and local level, the empirical literature indicates that the withdrawal of federal intergovernmental financial support since 1978 is likely to have led to some reduction in the level of state and local expenditures, though by not nearly so much as to compensate for the revenue losses.

Sixth, influenced both by these developments as well as more recently by cyclical factors, the finances of state and local governments have deteriorated markedly in recent years (Table 3).

Table 3.State and Local Government Receipts and Expenditures
(In billions of U.S. dollars)
Of which:
Personal taxes6.823.682.6140.2165.8173.7188.1
Corporate profits1.23.714.520.223.726.524.2
Indirect business taxes32.074.8174.5278.5314.0336.8358.2
Contributions to social insurance3.49.229.743.250.053.356.7
Federal grants6.524.488.799.7102.6111.4119.4
Of which:
Goods and services46.1119.4322.2465.6544.5587.6633.4
Transfer payments5.920.165.7101.1119.6130.3141.5
Net interest0.1-1.8-17.0-32.4-37.5-40.3-42.7
Surplus or deficit0.11.826.865.151.349.744.0
Social insurance funds2.36.927.151.363.771.178.0
(In percent of GNP)
Of which:
Personal taxes1.322.323.023.493.663.563.59
Corporate profits0.230.360.530.500.520.540.46
Indirect business taxes6.217.376.396.946.946.906.84
Contributions to social insurance0.660.911.
Federal grants1.262.403.252.482.272.282.28
Of which:
Goods and services8.9511.7611.7911.6012.0412.0412.10
Transfer payments1.141.982.402.522.642.672.70
Net interest0.02-0.18-0.62-0.81-0.82-0.83-0.82
Surplus or deficit0.020.180.981.621.131.020.84
Social insurance funds0.450.680.991.281.411.461.49
Source: Department of Commerce, Bureau of Economic Analysis, Survey of Current Business, Table 3.3, various issues.
Source: Department of Commerce, Bureau of Economic Analysis, Survey of Current Business, Table 3.3, various issues.

II. Rationale for Intergovernmental Flows

Against this backdrop of reduced real federal grants-in-aid to other levels of government, the U.S. Administration has outlined a broad strategy for reform in the areas of transportation and education where much of the responsibility for implementing that strategy would rest with the other levels of government. In order to evaluate that approach, some background on the economies of fiscal federalism is helpful.

The literature on fiscal federalism starts from the presumption that a case can be made for the superiority in certain circumstances of decentralized over centralized modes of government.3 This case is typically made by recognizing that the range of goods between pure public goods (to be provided at the national level) and private goods (to be market provided) includes local public goods such as fire protection and education, the benefits of which tended to be geographically delineated. A unitary form of government, given the likelihood that it would impose a uniform level of provision of such goods, would fail to account for varying preferences among the residents of different communities. Devolving decision making as regards local public goods to lower levels of government will ensure, it is argued, that the economic structure is sensitive to—and indeed can actually discover the nature of—preferences across jurisdictions. Specifically, the argument usually takes as its starting point some version of the Tiebout model and states that if there are a sufficient number of communities, individuals will reveal their true preference for local public goods by the choice of where they live.4

Against that background, one obvious case for intergovernmental grants arises from the fact that each local public good will have its own geographically defined benefit area and it is unlikely that these benefit areas would coincide neatly with the actual jurisdictions established at the lower levels of government. The result is potential for interjurisdictional spillovers that provide an efficiency basis for intergovernmental grants to correct for the associated externalities.5 Economic analysis would suggest that the ideal grant form would in these circumstances be a categorical grant6 that is open-ended and has a matching requirement.

An alternative efficiency argument arises in models of federal systems that allow for interjurisdictional migration. This argument follows from the observation that if all jurisdictions act noncooperatively, the resulting postmigration long-run equilibrium may well be nonoptimal but could be improved by resort to equalizing lump-sum transfers between communities. The nonoptimality of migration patterns can arise if residents of a province are entitled on the basis of residence alone to a share of publicly accruing rents in a state and/or locality. Migrants will then no longer respond solely to their marginal product (wage rate) when making migration decisions.7 However, these results are quite sensitive to underlying assumptions, in particular, to the assumption that the residence-rents accrue publicly rather than privately.

A related efficiency argument can be made based on migration in response to interjurisdictional differences in net fiscal benefits.8 However, interjurisdictional differentials in fiscal net benefits are also often viewed as providing an equity rationale for equalizing grants between jurisdictions.9 Briefly, the argument is based on the fact that fiscal activities can give rise to real interjurisdictional income differences that are not reflected in the measured personal incomes of individuals. Since the federal (income) tax/transfer system is based primarily on some measure of personal incomes, an additional instrument for redistribution is needed if the Federal Government is to be able to take account of the redistributive impact of policies at other levels of government when trying to achieve an overall equity goal. Equalization payments are held to constitute such an instrument.

A further rationale for intergovernmental transfers is that grants may be needed to correct an imbalance in revenue authority and expenditure responsibility between central and lower levels of government.10 This “fiscal gap” argument is based on the fact that even in the case where a jurisdiction has access to all revenue sources it may not be able to use those sources flexibly—for example, because of ease of migration, a state might not be able to maintain for long periods of time a state income tax system that has markedly higher tax rates than in other states. A more sophisticated version of the argument could recognize that even if states and/or localities could raise sufficient revenue it might not be desirable for them to do so on efficiency grounds—the allocative effects of the taxes used at lower levels of government (for example, property taxes) might be more severe than those associated with the federal income tax.

Economic analysis can, therefore, provide some guidance concerning the desirable structure of intergovernmental grants. That analysis, to be sure, may not be decisive in determining the level and structure of federal grants-in-aid—because the amount of information that would be required to gauge the severity of externalities, the differences of opinion that can be expected over the equity objective, and the size of any fiscal gap all suggest that there can be considerable latitude in establishing grant levels. However, economic analysis may be helpful in delineating an appropriate structure for intergovernmental relations in specific areas such as infrastructure and education.11

III. Infrastructure Investment

In the late 1970s and early 1980s concern grew that the stock of U.S. infrastructural capital was being inadequately maintained and developed.12 In reaction, the Congress in 1983 conducted a survey of the nation’s infrastructure problems and in 1984 established the National Council on Public Works Improvement (NCPWI) to assess the state of the infrastructure. That Council, in its final report issued in 198813 concluded that infrastructure outlays should be increased by as much as 100 percent. Also, the Surface Transportation Assistance Act of 1982 raised the federal gasoline tax by 5 cents a gallon with a view to increasing transportation outlays over the subsequent five years.

This section begins by reviewing recent developments in public sector capital formation before proceeding to consider the issue of how infrastructure investment might be financed in a federal system.

Recent Developments in Infrastructure Investment

One indicator of developments in U.S. infrastructure is the growth of the nonmilitary stock of government-owned fixed capital (Table 4). By that measure, there is clear evidence of a recent slowdown in the growth of the stock of infrastructure—the real net stock of government-owned capital, which increased at an annual rate in the range of 4 percent to 4½percent in the 1950s and 1960s, grew at about 2 percent a year during the 1970s and at an even slower pace during the 1980s. The growth rates in the 1970s and particularly in the 1980s are significantly less than those in output (GNP), implying a steady decline in the ratio of the stock of public capital to output.14 As regards developments at different levels of government, the changes in the growth rates at the federal level broadly parallel those at the state and local levels through the 1970s, though the growth rates at the federal level were persistently lower. Since about 1980, however, public sector capital formation at the federal level accelerated, though the impact of that acceleration on the total infrastructure stock has been diluted given the large share of the state and local sector in the total stock.

Table 4.Stocks (Excluding Military) of Government-Owned Fixed Capital(In billions of 1982 U.S. dollars unless otherwise noted)
Equipment and Structures1
FederalState and LocalTotal
Sources: Department of Commerce (1987 and 1989).

The rates of change are in parentheses and are expressed as annual rates from preceding observation.

Sources: Department of Commerce (1987 and 1989).

The rates of change are in parentheses and are expressed as annual rates from preceding observation.

A slowdown in the growth rate of the stock of public sector capital does not of itself necessarily imply that there is a problem. For example, in its review of the study by the National Council on Public Works Improvement, a Congressional Budget Office study cautioned against arriving at excessively strong recommendations for future infrastructure needs on the basis of a methodology that presumes that existing ratios, such as that of infrastructure investment relative to GNP, are optimal.15 Such an approach to analyzing infrastructure needs is excessively mechanical and insensitive to changes in economic circumstances.

For its part, the 1988 study by the Congressional Budget Office takes a disaggregated approach to evaluating infrastructure needs and suggests that the most important challenge in the area of infrastructure as a whole may be to effect a smooth transition from an era of construction to one of management—that is, the existing stocks of public capital are essentially in place (in the sense that one does not need two interstate highway systems) and what remains is the task of managing the stock more efficiently.

Efficient management could include the use of a different pricing policy for infrastructure. For example, the fact that highways are congested does not of itself point to an inadequate stock of public capital, particularly in the absence of tolls. If congestion fees were to be levied that reflected user contributions to congestion, the perception of the adequacy of existing infrastructure could be substantially improved.16 Again, changing the system of highway taxes to reflect the fact that trucks are disproportionately responsible for wear and tear on highways could result in a level of truck usage that would impose less damage on those highways.

Other research also has emphasized the importance of evaluating the economic contribution of infrastructure investment but has been less sanguine than the 1988 Congressional Budget Office study about the adequacy of the stock of public sector capital. In this connection, Aschauer17 concludes that the slowdown in infrastructure capital formation may have contributed to the slowdown in productivity growth that has been recorded in the United States in recent decades.18 However, the methodology used in his research involves time series regressions based on aggregate data where it is possible that all that is being observed is a correlation between the recorded decline in productivity growth and the slowdown in public sector capital formation.

That said, given the assumption that there will not be a dramatic change in pricing policy, the case for more public sector capital formation is presumably strengthened. In this connection, consider the U.S. Department of Transportation’s evaluation of future infrastructure needs in the areas of highways and airports and airways.19 As regards highways, the review presents estimates of the cost of maintaining overall current highway standards—which implies additions to capacity to meet increased demands—based on the federal highway administration’s biennial reports on the physical status of U.S. highways. According to the latest of these reports which covered 1987, although the situation had improved since 1983, about 28 percent of interstates, 40 percent of other arterials, and 55 percent of collector mileage were rated either as poor or approaching poor. On that basis, the Department of Transportation review estimates the shortfall at between $5 billion and $9 billion a year.

As regards airports and airways, the review estimates that the annual average total capital requirements in the period 1990–2015 will be between $7.7 billion and $8.2 billion (in 1989 dollars).20 This would represent a substantial increase over the recent levels of capital expenditures in these areas; for example, the total funding needs projected for airports is about $5.7 billion a year in contrast to actual expenditures in recent years of about $3 billion a year.21

Intergovernmental Relations and Infrastructure Investment

As noted above, many of the benefits generated by infrastructure investment are likely to be experienced locally. The theory of local finance would suggest as a starting point that therefore decisions concerning stock levels might also be made locally. A case for federal government involvement would arise if there was evidence of interjurisdictional spillovers. In the case of highways, particularly interstate highways, for example, some of the benefits accrue outside the locality in which the highway is constructed. The reality is that federal programs in this area involve matching grants that have ceilings where the matching rates are very high.22 It seems unlikely that the externalities are such as to warrant subsidy rates over 70 percent.23

Similar arguments can be made for other types of infrastructural investment. While it is not clear how high the matching rates should be—and in some cases they may be quite low—a case can be made for open-ended matching grants. In the specific case of airports and airways, interjurisdictional spillovers could be large. This is one area where federal involvement continues to be relatively significant.24

With this as background, consider trends in the Federal Government’s involvement in public sector capital formation. Tables 5, 6, and 7 present indicators of trends both in direct federal capital outlays and in the composition of capital grants for state and local governments. As Tables 5 and 6 show, the bulk of direct federal capital formation is in defense, which is projected to decline. Excluding defense what is notable about federal capital formation is its small and declining scale—nondefense capital formation has declined from about ½ of 1 percent of GNP in the 1950s to about ⅓ of 1 percent of GNP in recent years.25

Table 5.Direct Federal Outlays for Major Public Physical Capital Investment(In billions of U.S. dollars)
TotalNational DefenseNondefense


FY 1982


FY 1982


FY 1982

Source: Office of Management and Budget (1990).

Includes off-budget postal service investments of the following amounts: In billions of current dollars: 1989: $0.9; 1990: $1.4; and 1991: $2.3. In billions of constant (fiscal year 1982) dollars: 1989: $0.9; 1990: $1.3; and 1991: $2.0.

Estimates, Office of Management and Budget.

Source: Office of Management and Budget (1990).

Includes off-budget postal service investments of the following amounts: In billions of current dollars: 1989: $0.9; 1990: $1.4; and 1991: $2.3. In billions of constant (fiscal year 1982) dollars: 1989: $0.9; 1990: $1.3; and 1991: $2.0.

Estimates, Office of Management and Budget.

Table 6.Direct Federal Outlays for Major Public Physical Capital Investment
TotalNational DefenseNondefense


of TFO1

of GNP

of total

of GNP

of total

of GNP
Source: Office of Management and Budget (1990).

TFO refers to total federal outlays.

Includes off-budget postal service investments.

Estimates, Office of Management and Budget.

Source: Office of Management and Budget (1990).

TFO refers to total federal outlays.

Includes off-budget postal service investments.

Estimates, Office of Management and Budget.

Table 7.Composition of Federal Grants to State and Local Governments for Major Public Physical Capital Investment(In billions of U.S. dollars)
Urban mass transit0.
Community and regional development0.
Of which:
Block grants4.
National resources and environment0.
Of which:
Pollution control0.
Source: Office of Management and Budget (1990).

Estimates, Office of Management and Budget.

Source: Office of Management and Budget (1990).

Estimates, Office of Management and Budget.

As shown in Tables 1 and 2, federal outlays for grants-in-aid to state and local governments for capital purposes have been declining in real terms in recent years. Table 7 supplements these tables by providing a breakdown of these grants-in-aid. While most categories of capital grants are not growing or are declining in real terms—block grants for community and regional development and grants for pollution control are among those experiencing significant nominal cuts—grants for airports are expanding relatively rapidly though from a low base.

Subject to a couple of reservations, the data in these tables are not obviously inconsistent with the level of grants that might be indicated by fiscal federalism considerations. The two reservations are, first, the structure of grants, which by and large have ceilings, does not necessarily conform to the assumptions underlying the theoretical results, and, second, it is not clear why grant levels should be declining in real terms at a time when, all else (including pricing policy) held equal, prospective demands may be increasing.

Table 8.Capital Outlays of State and Local Governments(In billions of U.S. dollars unless otherwise noted)
Fiscal Year
(In percent of GNP)
Of which:
Local schools2.
Higher education0.

To this point the presumption has been that the only reason for federal grants-in-aid in this area arises from interjurisdictional spillovers. However, as noted in Section II, if there is a mismatch between revenue bases and expenditure responsibilities, then a further case can be made for some federal resource flows where these presumably should be in the form of block rather than categorical grants.26 In this connection, it is interesting to note from Table 8 that the share of state and local capital formation to GNP has declined significantly from the levels recorded in the 1950s and 1960s (though there has been a modest increase in highway construction in recent years). In addition, the lower levels of government have recently been experiencing increasing operating deficits that might compromise their ability to issue debt to finance infrastructure projects and that might lend support to the argument that further cutbacks in federal grants-in-aid in general could have an adverse impact.27 Moreover, in the specific context of transportation, to the extent that user fees are used to defray the cost of providing the infrastructure, those fees, depending on how they are levied, might preferably be raised at the federal level, to prevent interjurisdictional competition, and returned to other levels of government.28

In conclusion, it may be impossible definitively to determine either the optimal level of infrastructure investment in the United States (because it depends on imponderables such as pricing policy) or the relative responsibilities of the various levels of government in meeting infrastructure needs, particularly as they concern transportation. However, some studies indicate that state and local governments likely face increased demands in this area. In fact, in recent years an increasing number of lower-level jurisdictions have passed tax increases earmarked for specific purposes such as infrastructure; for example, California has enacted a gasoline tax increase for highways and mass transit.29 In that connection, continued real reductions in grants-in-aid at a time when the fiscal situation facing many states and local governments is deteriorating might serve to constrain the ability of the public sector as a whole to meet infrastructure demands.

IV. Education

This section reviews the general economics of the education industry and then considers how education fits into the fiscal federalism system in the United States.

Background on the U.S. Education System

Among those in recent years who have criticized the state of American schooling have been the Secretary of Education, the Carnegie Forum on Education and the Economy, and the National Governors’ Association. The evidence most frequently cited as demonstrating the existence of an educational “crisis” comes from two sources. First, the average combined score on the Scholastic Aptitude Test (SAT) fell from 958 in 1966 to 890 in 1979 and has only recently climbed back over 900.30 Second, international comparisons suggest that U.S. students at various grade levels are not as well prepared as their peers in other countries, particularly in “hard” areas such as mathematics.31 How one interprets data such as these depends on one’s view of the role of education. Specifically, those who see education as a form of human capital would tend to view these developments as boding poorly for U.S. competitiveness somehow defined.32 In contrast, those who view education as a screening device that serves to separate the most able from the less able would not be so concerned.33

Accepting that education at least in part serves to enhance human capital, the question then arises as to why the U.S. educational system appears to be performing so poorly. A recent paper by Rasell and Mishell (1990) claims to find at least a partial answer in the relatively low amount the United States devotes to education expenditures on grades kindergarten through 12. The authors argue that taking the share of GNP devoted to education at those grades, the United States ranks 14 out of 16 industrial countries. The relatively high share of GNP the United States spends on education as a whole is misleading, the argument goes, given the disproportionately large weight of tertiary education in the United States. However, the results of this paper have been subject to criticism. First, the data can be manipulated to produce alternative rankings that would cast the United States in a better light—for example, by focusing on absolute amounts spent on each student rather than on GNP shares. Second, there is the even more fundamental issue of what relationship, if any, there is between expenditure levels and the quality of the educational system.

Modern research on what determines the quality of education began with the report by Coleman and others (1966), which implied that differences in schools had little to do with differences in performance; rather, for an individual, family background and the characteristics of other students in the school seemed more important. This pathbreaking study has subsequently come to be viewed as flawed in its specific conclusions. However, it spawned a large literature attempting to estimate education production functions.34 If a consensus has emerged from that literature it is that there is little reason to believe that allocating more money to education would have a noticeable effect on the performance of students.35 Specifically, in his review of 147 studies in this area, Hanushek (1986) finds that, of the 112 estimates of the effect of class size on indicators of performance in education, only 23 were statistically significant and of these 14 displayed a significant negative relationship. Similarly, teacher education levels and teacher experience tended not to have a significant impact, though in the case of teacher experience there was some weak evidence pointing to the predicted positive impact on education output.36 Among the factors that are important in explaining student performance is family background.37

Education and the Role of Government

Before addressing the role that might be assigned to the Federal Government in education, consider the role the public sector as a whole might play. Unlike the earlier case of infrastructure investment, education is not a pure public good—evidence indicates that the marginal and average costs of educating an additional child, at least for large school districts, are approximately the same and moreover there is no difficulty in charging consumers of education for the services rendered.38

One line of reasoning in support of a public policy role in education has emphasized externalities arising, for example, from having an educated citizenry. However, given how large the private return to education appears to be, it is not obvious that large subsidies are warranted.39 Rather, the principal rationale for public support for education appears to rest on equity concerns about overreliance on the private financing of education. That is, there is a concern to ensure equality of opportunity. It may be noted that the public policy role in education to ensure equality of opportunity can be rationalized as a response to incomplete capital markets—children are not capable of borrowing for their education, hence local governments intervene with the solution of choice being local public provision of education.40

As regards its implications for federal policy, the criterion of equality of opportunity is sufficiently vague as to be consistent with a fairly broad range of views concerning the proper role of the Federal Government. A representative view might be that the Federal Government should accept responsibility for the additional educational demands due to special populations such as the handicapped.41 Moreover, the Federal Government should perhaps have a primary role in research and information-gathering and dissemination, because of the public goods nature of those functions. More controversial is the notion that the Federal Government should ensure minimum standards in education. This would imply, for example, that the Federal Government should become involved when states are felt to be doing an inadequate job.

Beyond these specific considerations, some have argued that to the extent that the U.S. educational system as a whole is not performing adequately then there may be a role for the Federal Government. However, in light of the empirical evidence indicating that increased aggregate expenditures per se will not have an appreciable impact on student performance, the federal role should not just be in terms of providing additional funding. In this connection, it is interesting to note that a recent study argues that the solution to an improved educational system lies in promoting greater autonomy of the public schools and in encouraging greater competition between schools—that is, the solution lies in the direction of ensuring that the educational system faces more appropriate incentives.42

With this as background, it is worth briefly considering the actual role of the public sector in U.S. education. As Table 9 indicates, that role is significant. Focusing on enrollments at the elementary and secondary levels, the share of private school enrollment declined during the 1960s but has been relatively stable thereafter at about one tenth of the total.43 The growth in public involvement in higher education was also pronounced in the 1960s and was related to a sharp increase in the proportions of any given age group attending college.

Table 9.Enrollment in Educational Institutions(In thousands unless otherwise noted)
Total enrollment44,49759,12458,21558,682
Elementary and secondary enrollment40,85751,11946,64545,595
Private (in percent)13.910.810.711.6
Public (in percent)
Higher education enrollment3,6408,00511,57013,087
Private (in percent)40.126.321.922.2
Public (in percent)59.973.778.177.8
Source: Department of Education (1989).


Source: Department of Education (1989).


The Federal Government’s financial role is small relative to that of the public sector as a whole. As can be seen from Table 10, the federal share of total public sector expenditures in support of elementary and secondary education, which increased in the 1960s and 1970s, has been declining in the 1980s and now stands at about 6½ percent. As regards the composition of federal expenditures at these levels of education, the bulk of the expenditures are under Chapter 1 (previously Title 1) for the educationally disadvantaged ($4.6 billion in appropriations in fiscal year 1989); funding for education of the handicapped ($2 billion in fiscal year 1989); and money for rehabilitation services and handicapped research ($1.7 billion in fiscal year 1989). These expenditures are broadly consistent with underlying theories of fiscal federalism.

Table 10.Public Elementary and Secondary Schools: Sources of Finance
(In millions of U.S. dollars)
Total revenue5,43714,74740,26796,881158,827
Federal Government1566523,2209,50410,146
State Government2,1665,76816,06345,34979,023
Local sources3,1158,32720,98542,02969,659
(In percent of total)
Federal Government2.
State Government39.839.139.946.849.8
Local sources57.356.552.143.443.9

To this point, the discussion has focused on issues associated with the level and financing of aggregate expenditures on education. Reflecting the concern to ensure equality of opportunity, there also has been a continuing debate over how to obtain an appropriate distribution of those resources across school districts. The background is one where the variance in expenditures for each student across school districts can be very large.44 The debate has frequently been conducted within the legal system. Most notable was the 1971 ruling of the California Supreme Court (Serrano v. Priest) to the effect that the existing manner in which that state’s public schools were funded was unconstitutional—the ruling held that the heavy reliance on local property taxes to fund education implied that the right to education was inappropriately conditioned on wealth. Subsequently, there have been similar decisions in a number of other states that interpreted states’ constitutions as imposing requirements upon states to ensure that all students receive an adequate education.45 Interestingly, the U.S. Supreme Court in 1972 ruled that the Texas system of local funding for education did not violate the “Equal Protection Clause” (Fourteenth Amendment) of the U.S. Constitution.46

The practical result of these rulings has been for states to become increasingly involved in education. This change is evident in Table 10, which documents the growing importance of state funding in education.

More basically, the earlier discussion of the theory of fiscal federalism pointed to the possible need for fiscal equalization payments to compensate for revenue-expenditure mismatches between the various levels of governments. Education may afford such an example. The ability of poorer local districts, where the need for public education may be the greatest, to finance that education may be severely circumscribed by limited tax bases, suggesting the need for assistance from higher levels of government. Traditionally, the relevant higher level of government has been viewed as the state level of government. Analysis of this issue is complicated by the fact that income redistribution policies are commonly viewed as being most appropriately handled at the federal level.47,48

To conclude, while there may be a case for arguing that the U.S. education system is troubled, it is not clear that a greatly enhanced federal financial role would necessarily be the appropriate response. The evidence indicates that greater resources in the aggregate would not achieve much, and the theory of fiscal federalism, to the extent that it provides any guidance, would tend to suggest that most jurisdictional questions can be handled at the state-local level.49

V. Concluding Observations

This paper has reviewed developments in intergovernmental relations in the postwar era and considered those developments in light of the economics of fiscal federalism. It was concluded that the results of the theoretical literature could be consistent with a broad range of views on how the (financial) role of the Federal Government vis-à-vis other levels of government should be managed.

As regards some specific areas of interest, while a case may exist for increased infrastructural investment, the Federal Government’s responsibility in this area is less clear. However, the fact that state finances have deteriorated rapidly suggests that some moderation in the secular decline in real grants-in-aid might be desirable. Underlying this is the complex issue of how to raise the requisite revenue to support expenditures at all levels of government most efficiently.

Concerning education, while the education industry may be troubled, there is a question whether an increase in aggregate public expenditures in this area is the solution. Instead, attention might need to focus on more micro phenomena such as the high variance in expenditures across school districts and the need to ensure that school districts face appropriate incentives.


    Advisory Commission on Intergovernmental RelationsDevolving Selected Federal-Aid Highway Programs and Revenue Bases: A Critical Appraisal (Washington1987).

    ArrowKennethJ.“Higher Education as a Filter,”Journal of Public EconomicsVol. 2 (July1973) pp. 193216.

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There is voluminous literature documenting the problems in these two areas. Among the pieces having the greatest impact on initiating the public debate on these topics are Choate and Walter (1983) and the National Commission on Excellence in Education (1983).

The Administration’s views on how to address the transportation needs of the United States are contained in Department of Transportation (1990a); the Administration’s involvement in its leadership role in education is exemplified by the Education Summit convened by the President with the U.S. Governors on September 27–28, 1989.

For more detailed analyses of the economics of federal systems, see Oates (1972), Atkinson and Stiglitz (1980), and Stiglitz (1983 and 1988).

Tiebout (1956). The simple Tiebout framework was subsequently modified and extended in a number of ways. For example, Tiebout assumed an exogenous set of communities. Buchanan relaxed this by considering the issue of optimal club (that is, community) size, which in turn would indicate the optimal number of clubs for a given population (Buchanan (1965)). Other elaborations took account of differences in income or earnings power across individuals (Atkinson and Stiglitz (1980)).

For example, Williams (1966).

For elaboration on grant taxonomies, see Wilde (1971), Oates (1972), and Bahl (1986).

Boadway and Flatters (1982) and Krelove (1988).

The net fiscal benefit a resident derives from governmental activity is defined to be the difference between the benefits received from public sector expenditures and regulation and the taxes that a resident pays.

The equity rationale for equalizing payments as compensation for differentials in fiscal net benefits was originally couched as an extension of the notion of horizontal equity—that is, individuals at a given income (utility) level should be treated in like manner by government policy. Subsequently, however, the efficiency implications of these differentials received more attention. See, for example, Buchanan (1950 and 1952), Scott (1952), Buchanan and Goetz (1972), and Flatters, Henderson, and Mieszkowski (1974).

One further theoretical caveat might be noted. While the Tiebout model, which underlies much local public finance analysis, can be viewed as a means of resolving the issue of preference revelation for the case of local public goods, the argument that it provides a framework within which an efficient local public goods equilibrium is generated may not be so valid. As that argument goes, a private competititve equilibrium can be applied by analogy to the case of local goods provision. However, first, the number of communities involved may be relatively small, leading potentially to noncompetitive behavior. Second, and more serious, the nature of (local) public goods is such that the conditions needed in order to ensure that a competitive equilibrium is sustained are violated. As a result, there may be no equilibrium or there may be multiple equilibria with the economy sitting at a suboptimal point.

See, for example, Choate and Walter (1983).

National Council on Public Works Improvement (1988). Other reports produced in the early 1980s calling for varying amounts in increased infrastructural investment included reports from the Associated General Contractors (America’s Infrastructure) and the Joint Economic Committee (1984).

In some recent years the per capita real stock actually declined.

On the appropriate treatment of congestion, see Ebrill and Slutksy (1982). An interesting polar case occurs in the case of homogeneous congestion—if congestion levels are unaffected when the size of the facility and usage are doubled, then given constant returns to scale, the optimal toll will generate enough revenue to finance that facility.

In particular, one of his results is that a $1 increase in the stock of public infrastructure adds about as much to productivity as a $4 increase in the stock of private business capital (Aschauer (1989b)). Schultze (1990) has noted that while this may not constitute a free lunch, it does represent a very cheap banquet!

Department of Transportation (1990b). This report considers all modes of transportation.

Specifically, federal contributions are 90 percent for the interstate highway system, 80 percent for bridge replacement and rehabilitation grants, and 75 percent for primary, secondary, and urban programs. Department of the Treasury (1985), p. 159.

Even in the case of interstate highways, the benefits often accrue locally—for example, most of the traffic on the Beltway around Washington, D.C., is local.

As regards its composition, the most important component concerns water and power projects.

Bahl (1986) refers to this as vertical equalization.

In that regard, it is worth noting that the Advisory Commission on Intergovernmental Relations (1987) recommends a further devolution of highway responsibilities to lower levels of government with sufficient additional revenue sources—implicitly a fiscal gap argument. This type of proposal, of which there have been many, is referred to as a “turnback.”

In this connection, in 1982 the Congress moved to implement a fee structure that would have reflected more accurately the damage various categories of vehicles inflict on highways—the maximum heavy vehicle-use tax was to be increased from $210 a year to $1,900 a year—but the fees were subsequently capped at $550 in the Deficit Reduction Act of 1984 with the lost revenue being recouped by increased diesel fuel taxes. Department of Transportation (1990b), p. 10–24.

In this connection, it is also worth noting that highway expenditure needs may vary widely from state to state, suggesting a state-based rather than a nationwide problem; for example, while 11.1 percent of the interstate system was rated in 1987 as poor, that figure was 45 percent for Missouri but only 1 percent or less in eight states.

Hanushek (1989). See Hanushek (1986) for a discussion of the strengths and weaknesses of SAT test scores.

See Mincer (1970) and Becker (1975) for a review of the “human capital” literature.

See, for example, Stiglitz (1975) and Arrow (1973).

Hanushek (1986). There are numerous measurement problems in this area of the empirical literature. As an example of a recent study looking at how to measure school district performance see Fare, Grosskopf, and Weber (1989).

Hanushek (1986, pp. 1164–65) is at pains to point out that the results should not be interpreted as implying that teacher skills are irrelevant; rather, such a variable is very difficult to measure,

In a related vein, there is evidence that parental income can have an important impact in the sense that access to college may be more difficult for those who are liquidity constrained (Taubman (1989)).

A further rationalization for government intervention arises if education is viewed as a merit good. This rationalization is consistent with rules mandating school attendance.

Chubb and Moe (1990). Competition is to be encouraged by giving parents greater choice as regards the schools they select. This could be effected by a voucher system that would allow parents to send their children to the best school they can find.

This decline reflected a decline in Catholic school enrollment (Hanushek (1986)). Movements in the absolute numbers reflect the passage of the baby-boom generation.

For example, Congressional Research Service data indicate that in 1986–87 for elementary schools in New York state, expenditures for each pupil in the richer school districts were $10,349, compared with $3,939 for the poorer school districts. Corresponding figures for California were $5,343 and $3,172; for Illinois, $4,266 and $2,116; and for Texas, $5,243 and $1,848.

In fiscal year 1987, about one half of local government own source revenue was derived from property taxation. Tax Foundation (1990).

The methods used to calculate intrastate equalization payments for education have tended to be much more sophisticated than those used for interstate payments such as revenue sharing. Department of the Treasury (1985).

A review as brief as the one here of necessity is limited in scope. Among the issues not discussed here is whether the federal system could beneficially influence the private component of education as, for example, through tuition tax credits (Martinello and West (1988)).

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