The Promises and Pitfalls of Fiscal Federalism

>> Audience 1: So you mentioned that grants to local governments usually lead to more efficient allocation resources because of better understanding preferences. But when do nonprofits, or even like smaller local corporations, actually do a better job at resource allocation? Do you think there is actually an information advantage in that kind of specialization from even more local institutes?

>> Jeffrey Clemens: Sure, absolutely, and I wanna highlight that I didn't mean to imply that it's a guarantee that sending the money to the local levels of government will generate more efficient service provision. So in particular, there's just a standard economic incentive based reason for worrying about this. So if you think about the design of the Medicaid program, which is a program that I've done a fair bit of my own research on over the years, the federal government covers a majority of states expenditures, and it comes in the form of what we call a matching grant, which is to say that the states kind of spend money and then they basically send their receipts to the federal government.

And it's a little bit more complicated than this, but there's a share of those expenditures that get sent back, okay? Well, when someone else is subsidizing a share of your expenditures, your incentive to deliver the services efficiently is blunted. This would tend to be related to arguments about the extent to which the federal financing that we're talking about would best be delivered via what we would call a block grant, where it just comes as a lump of money not distorting the incentive to deliver the services efficiently on the margin.

And you can ask then, well, why does the federal government like matching grants more than block grants? And one of the reasons would be that it's that incentive that the federal policymakers are using to kind of push the states to do more because they're making it less costly for them to do more.

So I would tend to expect the incentives for efficient service delivery to be stronger in the context where it's a block grant as opposed to a matching grant. But matching grants account for the majority of the intergovernmental grants that we see in large part because Medicaid is such a large program.

And I completely share your intuition that at the even more local level, that the role of nonprofits and it could be a combination of religious and non religious organizations in delivering various forms of, whether it's welfare assistance or other public services, is not something that this talk is meant to discount at all, because indeed they are the most local actors who have the most direct contact with beneficiaries and do have a very important role to play.

This talk is very much kind of, it's sort of, I guess, as highlighted on this closing slide, it's very much kind of picking up the ball after we've made a collective decision that the government is going to do something. It's then a talk about, well, how should we think about which layer of government is likely to do the best job.

But of course, preceding that should be a conversation about whether it's an appropriate space for the government to be involved. Full stop.

>> Audience 2: For the purpose of improving outcomes in the US education system, should education spending be classified as locally concentrated, where it's having dispersed benefits? And how would you adjust education spending to best align with these economic roles?

>> Jeffrey Clemens: So education is one of the policy spaces that kind of primes some of the most subtle and interesting issues to think about and that kind of push in both directions. So on the one hand, we tend to expect to get more efficient delivery of services when we take advantage of some of the forces that are highlighted by the theory of fiscal federalism, which is to say if the locals are the ones who are paying, then the locals are going to be the ones who can kind of keep a hawkish eye on whether wasteful expenditures are taking place and try to root out waste in that sense.

On the other side of the equation, there's the fact that the building up of human capital is something that will tend to have benefits that extend beyond the local jurisdiction in which the provision of the education takes place. And so both in terms of kind of long run human capital development, but also in terms of some of the themes that are related to equality of opportunity and redistribution of the opportunity to become a high human capital individual who can potentially be a source of innovation and business growth in the United States, there's going to be a rationale for having some of the funding come at a higher level of government that is capable of sort of shifting resources to make sure that some of the individuals in low resource or low income communities are still, you know, getting a high quality education and are able to, you know, to exhibit mobility over the long run.

So those factors, it's very difficult to arrive at some sort of uniform conclusion. And of course, it's going to depend a lot on what's going on in implementation in any particular school district. If you show me a highly kind of corrupt and wasteful school district, I'll say, well, incentives probably aren't strong enough here.

We need to do something to try to get this place to perform better. But if you show me a scrappy school district that is managing to propel students to Ivy League and other highly ranked institutions despite having relatively low resources, I'd kind of highlight that as a place where, if anything, we might want to ship in more resources to really help them take advantage of their high productivity at producing the educational services.

When I look at the landscape as a whole, it's kind of, it's a little tough. I mean, I personally, although the federal government is not particularly involved, I think it's, it's exerting more influence than it needs to in terms of the strings that it attaches to the relatively small number of dollars that it puts into the education system.

So the federal role is relatively modest, so the state and local governments together are accounting for more than 90% of the school finances. And it makes it such that the debate over federal education policy for K through 12 is kind of overwrought. And kind of reducing the federal footprints would tend to be in line with my policy preferences.

But that's about as far as I'd feel confident making very specific recommendations. So the legal questions here, unfortunately, are beyond my pay grade or outside of my discipline. So I can't speak to the particulars of what the prevailing law is or how the Supreme Court is likely to push it one way or another.

But I would highlight that this style of provision that your question references, namely the idea of saying, well, look, to use my example from the talk, if Delaware decides to have an extremely generous cash welfare assistance program, it should worry that it will then become a magnet for potential beneficiaries for that program.

And so in that context, being aware of that incentive, a sensible policy move for Delaware to attach to the generous welfare program would be a residency requirement of this sort. Namely to say, okay, yes, so it's a generous program, but you have to establish residency here for some number of years before you can take advantage of the program.

That would be a sensible, from an economic perspective, that would be a very sensible way to try to dampen the incentives that might lead that program to unravel. And so to the extent that the states are allowed to sort of attach provisions of that sort to their redistributed programs, I would expect them to kind of be able to sustain a higher level of redistribution before, before things would be at risk of unraveling.

But I really can't speak to the current case law, unfortunately.

>> Audience 3: So I've done quite a bit of work with local and state government. I really love that area. And kind of the most blaring concern nowadays is this new trend of unfunded mandates coming from the federal level.

And so I was wondering if you could explain kind of from an economic perspective, what challenges that is posing to localities and also just the fiscal federalism model as a whole?

>> Jeffrey Clemens: Yeah, so on some level, I think that in terms of, and this is more of a political science comment than an economics comment for my kind of opening here.

On some level, of course, state and local officials should be annoyed when the federal government enacts a mandate of any sort, funded or unfunded, but they should be particularly annoyed when the federal government enacts an unfunded mandate because it's telling them to do something and come up with the money yourself.

So that's unpleasant. And to the extent that they have constitutional law working in their favor, I would expect state legal armies to try to push against that. And that's part of the healthy checks and balances of a federal system, is that the states should be able to push against that and to attempt to get the federal government to say, if we're going to force you to do something, then perhaps you should pay for it.

On the other hand, to the extent that the services that we're talking about are ultimately appropriately thought of as local or state level public services, the residents of the states would be the ones who receive them. And so from that perspective, it's not crazy to ask the states then to also be the ones that cook up the financing for those programs.

So it's going to become a matter of degree, and it would really be in the settings where the federal government is kind of dramatically pushing some of the states to go beyond what the local citizens would have preferred to do had they not been on the receiving end of the mandate from the federal government, where that tension is going to be strongest.

So I would think of that, I would think of the gist of your comment as just very much fitting sort of within the broad kind of theme of things that are in play within a federal system. So a lot of times, I don't know if this would be more economist or political scientists, but we talk about political scientists would talk about different layers of government or different branches of government being kind of jealous of their powers and hence sort of maintaining sort of a little bit of a relationship of conflict over who has authority for what.

And I guess in my talk, I did indeed sort of emphasize that there has emerged conflict over who has authority over what. If that conflict becomes extreme, one of the costs, I think, is precisely sort of what you highlight, namely that the healthy cooperation that might be needed in a variety of settings might then erode.

So in a healthy system of fiscal federalism, I would expect the layers of government to be jousting with each other a bit over who has responsibility for various functions. But I wouldn't want that to get to a point where, when cooperation is needed, and as you highlight, sort of with vaccine distribution being a key example, where we thought very little about, at least as public finance economists, about the role of counties for most of my adult or professional life up until the pandemic.

But because the counties run the public health departments, they were central for the administration of vaccines. And so then when such a crisis arises, you hope that the counties have functional communication with the state level governments, which were receiving allocations of vaccines from the federal government. So you're absolutely right that cooperation is a key part of a healthy system of fiscal federalism, just as some of the competitive elements are also kind of a key part of a healthy system.

>> Audience 4: I was wondering if you could say more about how federal grant makers decide the relative share that each state gets of a given federal grant, especially if you think that system is very good at matching the need that a given state might have for that money. And if you think there are any bad incentives that exist there.

>> Jeffrey Clemens: Sure. And this is one of my favorite research topics. I very much appreciate the question along those lines. I mean, so we saw in the pandemic, and this is the focus of some of my own research, that an unprecedented amount of federal money was allocated to the state and local governments on a completely ad hoc basis, right.

So we're talking about $900 billion, so about just over 4% of GDP being administered through completely kind of ad hoc, pandemic driven grants. So how did they choose how to split that money across the states, is the question. Well, it's not easy to admit. Sometimes we look at the federal government, we think, wow, looks like it's really easy for the federal government to spend money, but in fact, it's not that easy to spend large amounts of money on a purely ad hoc basis.

And so a fair amount of what they did was basically to take pre existing formulas that had been used to divvy up the highway funds or that were used to reimburse the state Medicaid programs. And they basically augmented those formulas or they said, we're going to. Similarly, for the school districts, they basically took the title one formulas that are used to distribute federal funds to the school districts and said, here's another $100 billion that's going to be divvied up around the country, $100 billion that's going to be divvied up around the country using those formulas.

So that's when spending large quantities of money without having a lot of time to think about design, that tends to be what's done. That was true on a very large scale in the pandemic, was true on a pretty large scale in the context of the great Recession and on a much smaller scale in the context of the 2001 recession.

In addition to drawing on those kind of prior formulas, there's then, of course, also political jockeying. So to the extent that you're exerting a high leverage vote in the Senate in particular, but also in the House, you've got an opportunity to try to get some of the dollars shifted towards your jurisdiction.

And the focus of some of my research in this area was on the fact that the small states, the low population states, which, of course, have disproportionate representation to a little, to a small extent in the House, but really to a significant extent in the Senate, were able to get the formulas for general fiscal assistance set up in a way that was quite beneficial to them.

So some of the big states around the country were getting aid that amounted to roughly $2,500 per resident. The smallest and hence the lowest population and hence, most represented states were getting on the order of $5,500 per resident. Now, of course, those are low population states. So the amount of money that was in play there was ultimately, it was something like kind of an extra 20, $30 billion, which is a lot, but is 3% of 900 billion.

So it looks like a modest amount out of that giant pie. But per resident, we're talking about an extra $3,000 per. For some of the other programs that have been sort of more deliberatively decided and designed. You know, the more kind of conventional criteria that are associated with kind of formulas that would describe different levels of need, in particular, tend to be the kind of central to the way that the grants are divvied up.

So highway funds are divvied up based on measures of literally how many bus miles and train miles are being traveled within a state over the course of a year. The Medicaid formulas, the cash welfare assistance. These programs tend to tend to have at least some benchmarking to differences in economic need.

So states with low average income per capita tend to get more generous allocations than states with high income per capita. And so you can see a real and pretty sensible debate over redistribution of federal dollars taking place in some of those contexts. Whereas in the kind of emergency we're spending money while our hair is lit on fire, you tend to see the political factors pop up a little more deliberately.

>> Audience 5: My question is kind of a little bit more about taxation and budget. So I was curious about in some of the graphs you presented, it seemed that sales tax provided a pretty large portion of the graph for state and local governments. Does that tie sales tax to certain programs?

And then if so, what occurs? If there is a discernible difference in spending by that state due to high taxation or low employment or whatever might occur, then what is the outcome of that program, if so?

>> Jeffrey Clemens: So that gets us some issues that I'm on, which my knowledge is a bit weaker than in others.

So it certainly is the case that sales taxes can be in some sense directly benchmarked to particular lines of spending. Now, of course, to the extent to which the amount of money that's kicked into, say, schools or parks, from the sales tax falls below the amount that the state or local government would have been inclined to spend in total, then the fungibility of resources kicks in and we wouldn't expect it to actually be binding in the end, although it sets a I'm not aware of research that has really dug into the question of whether those kind of specific earmarking arrangements tend to be associated with more or less efficient delivery of the services.

But that certainly would be an interesting question to pursue.

>> Audience 6: My question is, so you mentioned in the beginning of your talk that people are voting with their feet, and of course it is easier than ever move to a new state with favorable policies. But, for example, in California people, the largest group of people moving out is high income earners.

But we haven't seen a direct change in policy of these high income earners or of the politicians changing policy to support their programs that they support. With political divide in America, how do you see the future of decision making and policy funding at the statewide level whenever the repercussions aren't said considered?

>> Jeffrey Clemens: So first, I wanna point out that there's a long-running tension just in the facts about mobility that raise questions about kind of how sort of primed these forces of high income folks leaving high tax jurisdictions will be in the future. The tension is that although the cost, the resource cost of moving is lower than ever.

Fan transit and whatnot is less expensive. You can reach your relatives via FaceTime and hence have less of the separation that would have been associated with a move across the country in the old times. But at the same time, the actual number or sort of fraction of the population that moves across state lines in any given year has kind of been on a trend decline.

And so there's an interesting question of why and whether that just reflects people at least kind of around the country as a whole, sort of being relatively satisfied with staying in the state that they happen to be in. This is one of these issues that in kind of the wake of a major shakeup like the pandemic, I think it'll be another sort of interesting opportunity to see how activated those margins are.

And as we look around the country, we do see that some of the jurisdictions that you might think of as the kind of relatively high tax, and in some cases, we always pick on Illinois and Chicago or the most corrupt, those states are indeed starting to exhibit declines in population.

So California has sort of stagnated in terms of population growth. Illinois, I believe, has actually declined over the last several years. New York has also stagnated and maybe on a bit of a decline at this point. And so those states are going to start realizing pressures. One of the issues that Josh has done a great deal of research on involves the unfunded pension obligations that those states are sitting on.

And declining population becomes a real problem if you've got a fixed sitting obligation to the tune of hundreds of billions of dollars on the books, because as people disappear, that obligation is being spread across even fewer residents. And so you could see some degree of a spiral that starts to push people out faster and faster.

But whether that will actually be realized or not remains to be seen. It's something that we do need to keep a very close eye on. And if population starts to decline at kind of less trivial rates in some of these states that are realizing declines, the pressure for them to reform and come up with ways of reducing those obligations or other expenditures will become potentially fairly extreme.

>> Audience 7: I was instructed to stand up. So my question is, in regards to the conflict question that was asked earlier, specifically, if we know that these actors are self-motivated, like you mentioned, and they're all making analyses of their own utility interests based on efficiency, what happens when they come into conflict?

And can fiscal federalism give us an answer as to who will be the adjudicator when it comes to maybe a state has a different imperative on a certain issue. They want to give money to corporations and the federal government with specific constitutional parameters wants to give it to a different population.

So how would fiscal federalism handle those disputes?

>> Jeffrey Clemens: So I guess there are different dimensions of those disputes which would get handled in different ways. So when it's a dispute over authority, that will tend to be a legal question, right? And so the kind of combatants would have to spar in the courts.

You know, this could get back to the mandate question that we had previously. Is this mandate or that mandate actually consistent with the authority of the federal government as embodied in the constitution? So the lawyers would have to settle that. And hopefully those state and local policymakers, federal policymakers will abide by the adjudication of the courts.

On other questions, I would think of things through the lens of economic incentives. When there's conflicts, whether it's, for example, if it's a conflict where different jurisdictions are just sort of opting to provide different levels of resources or kind of set out different social policies. Then the people decide and the jurisdictions that have set things up in an efficient way and that tailors to large constituencies will grow, and the jurisdictions that have set things up in an inefficient way or that are sort of tailoring to disappearing constituencies will contract.

And that type of kind of conflict and competition is the kind of the power of fiscal federalism and economic incentives just sort of working in a direction that I think we should all think of as being a positive. And that people are finding their way to places that are delivering public services that they want, and they're doing so in hopefully a way that isn't heinously inefficient.