17 Federalism: How is revenue shared?

Fiscal Federalism: How are the people’s dollars distributed?

Federal, state, and local governments depend on different sources of revenue to finance their annual expenditures.

Two important developments have fundamentally changed the allocation of revenue since the early 1900s. First, the ratification of the Sixteenth Amendment in 1913 authorized Congress to impose income taxes without apportioning it among the states on the basis of population, a burdensome provision that Article I, Section 9, had imposed on the national government.^[1] This change significantly increased the federal government’s ability to raise revenue and spend it.

The second development regulates federal grants–transfers of federal money to state and local governments. These transfers, which do not have to be repaid, are designed to support the recipient governments, but also to encourage them to pursue federal policy objectives they might not otherwise adopt. The expansion of the federal government’s spending power has enabled it to transfer more grant money to lower government levels, which has accounted for an increasing share of their total revenue.^[2]

The sources of revenue for federal, state, and local governments are detailed in Figure 3. Although the data reflect 2013 results, patterns revealed in the figure give us an idea of how governments funded their activities in recent years. For the federal government, 47 percent of 2013 revenue came from individual income taxes and 34 percent from payroll taxes, which combine Social Security tax and Medicare tax.

How are the revenues generated by people’s tax dollars and people’s fees paid for public services and licenses put to use by different levels of government? To gain insight on this question check Article I, Section 8, of the Constitution, assigning the federal government various powers allowing it to affect the nation as a whole.^[3]

The 2014 federal budget demonstrates that providing for the general welfare and national defense consumes much of the government’s resources—not just its revenue, but also its administrative capacity and labor power.

Educational expenditures constitute a major category for all levels. However, whereas the states spend comparatively more than local governments on university education, local governments spend even more on elementary and secondary education. Local governments allocate more funds to police protection, fire protection, housing and community development, and public utilities such as water, sewage, and electricity. While state governments allocate comparatively more funds to public welfare programs, such as health care, income support, and highways, both local and state governments spend roughly similar amounts on judicial and legal services and correctional services.

The national government’s ability to achieve its objectives often requires the participation and cooperation of state and local governments. Intergovernmental grants offer positive financial inducements to get states to work toward selected national goals. A grant is commonly likened to a “carrot” to the extent that it is designed to entice the recipient toward a specific goal. On the other hand, unfunded mandates impose federal requirements on state and local authorities. Mandates are typically backed by the threat of penalties for non-compliance and provide little to no compensation to carry out the mandated action. Thus, given its coercive nature, a mandate is commonly likened to a “stick.”

Grants

The national government has used grants to influence state actions as far back as the Articles of Confederation when it provided states with land grants. In the first half of the 1800s, land grants were the primary means by which the federal government supported the states. Millions of acres of federal land were donated to support road, railroad, bridge, and canal construction projects, all of which were instrumental in piecing together a national transportation system to facilitate migration, interstate commerce, postal mail service, and movement of military people and equipment. Numerous universities and colleges across the country, such as Ohio State University and the University of Maine, are land-grant institutions because their campuses were built on land donated by the federal government. By 1900, cash grants replaced land grants as the main form of federal intergovernmental transfers and have become a central part of modern federalism.^[4]

Federal cash grants have strings attached; the national government wants public monies used for policy activities that advance national objectives. Categorical grants are federal transfers formulated to limit recipients’ discretion in the use of funds and subject them to strict administrative criteria that guide project selection, performance, and financial oversight, among other things. These grants also often require some commitment of matching funds. Examples are Medicaid and the food stamp program–categorical grants. Block grants come with less stringent federal administrative conditions and provide recipients more flexibility over how to spend grant funds. Examples of block grants include the Workforce Investment Act program, which provides state and local agencies money to help youths and adults obtain skill sets that will lead to better-paying jobs, and the Surface Transportation Program, which helps state and local governments maintain and improve highways, bridges, tunnels, sidewalks, and bicycle paths. Finally, recipients of general revenue sharing faced the least restrictions on the use of federal grants. From 1972 to 1986, when revenue sharing was abolished, upwards of $85 billion of federal money was distributed to states, cities, counties, towns, and villages.^[5]

During the 1960s and 1970s, funding for federal grants grew significantly, as the trend line shows in the figure above. Growth picked up again in the 1990s and 2000s. The upward slope since the 1990s is primarily due to the increase in federal grant money going to Medicaid. Federally funded health-care programs jumped from $43.8 billion in 1990 to $320 billion in 2014.^[6]

Health-related grant programs such as Medicaid and the Children’s Health Insurance Program (CHIP) represented more than half of total federal grant expenses.

The national government favors using categorical grants to transfer funds to state and local authorities because this gives them more control and discretion in how the money is spent. In 2014, the federal government distributed 1,099 grants, 1,078 of which were categorical, while only 21 were block grants.^[7]

In response to the terrorist attack on the United States on September 11, 2001, more than a dozen new federal grant programs relating to homeland security were created, but as of 2011, only three were block grants.

There are a couple of reasons that categorical grants are more popular than block grants despite calls to decentralize public policy. One reason is that elected officials who sponsor these grants can take credit for their positive outcomes (e.g., clean rivers, better-performing schools, healthier children, a secure homeland) since elected officials, not state officials, formulate the administrative standards that lead to the results. Another reason is that categorical grants afford federal officials greater command over grant program performance.

Block grants have been championed for their cost-cutting effects. Unfortunately, their flexibility has been undermined over time as a result of creeping categorization, a process in which the national government places new administrative requirements on state and local governments or supplants block grants with new categorical grants.^[8]

Among the more common measures used to restrict block grants’ programmatic flexibility are set-asides (i.e., requiring a certain share of grant funds to be designated for a specific purpose) and cost ceilings (i.e., placing a cap on funding other purposes).

Unfunded mandates are federal laws and regulations that impose obligations on state and local governments without fully compensating them for the administrative costs they incur. The federal government has used mandates increasingly since the 1960s to promote national objectives in policy areas such as the environment, civil rights, education, and homeland security. One type of mandate threatens civil and criminal penalties for state and local authorities that fail to comply with them across the board in all programs, while another provides for the suspension of federal grant money. These are commonly referred to as crosscutting mandates/requirements. Failure to fully comply with crosscutting mandates can result in punishments that normally include reduction of or suspension of federal grants, prosecution of officials, fines, or some combination of these penalties. If only one requirement is not met, state or local governments may not get any money at all.

Some mandates include partial preemption regulations, whereby the federal government sets national regulatory standards but delegates the enforcement to state and local governments. For example, the Clean Air Act sets national air quality regulations but instructs states to design implementation plans to achieve such standards.^[9]

The widespread use of federal mandates in the 1970s and 1980s provoked a backlash among state and local authorities, which culminated in the Unfunded Mandates Reform Act (UMRA) in 1995. The UMRA’s main objective has been to restrain the national government’s use of mandates by subjecting rules that impose unfunded requirements on state and local governments to greater procedural scrutiny. However, since the act’s implementation, states and local authorities have obtained limited relief. A new piece of legislation aims to take this approach further. The 2015 Unfunded Mandates and Information Transparency Act, HR 50, passed the House early in 2015 before being referred to the Senate, where it waits committee consideration.^[10]

Some leading federalism scholars have used the term coercive federalism to describe or label this aspect of contemporary U.S. federalism.^[11]

In other words, Washington, D. C. has been as likely to use the stick of mandates as the carrot of grants to accomplish its national agenda. As a result, there have been more instances of confrontational interactions between the states and the federal government.