State and Local Fiscal Behavior and Federal Grant Policy PURCHASES BY STATE AND LOCAL GOVERNMENTS have long been the most rapidly rising component of aggregate demand. While real consumption and investment expenditures have both doubled since the end of the Korean war, and federal purchases have increased barely at all, state and local purchases of goods and services have almost tripled. They have grown at an annual average rate of 5.5 percent and now account for over 10 percent of real gross national product (GNP).For much of this period, the budgetary surplus for state and local governments hovered very close to zero, being negative as often as positive and never amounting to more than $2 billion. Recently, however, the surplus has grown at a remarkable rate. It was only $0.7 billion as late as * We have benefited from the comments of several members of the Brookings panel, and also from discussions with Frank de Leeuw, has supplied us with unpublished national income accounts data, Joseph Valenza ably assisted with the computer work, Su Nokkeo with data preparation, and Kathryn Breen and Patricia Sachs with the typing. Some of the results in the paper are taken from an Urban Institute study, financed by the Office of Economic Opportunity, on the distributional aspects of urban fiscal behavior. A preliminary report on this project can be found in 1969 but then began a rapid expansion, reaching $4.8 billion in 1971 and $12.3 billion in 1972-when it attained an annual rate of almost $20 billion in the fourth quarter. Though special factors have accounted for some of this rise, a 1972 report on the fiscal policies of President Nixon and Senator George McGovern predicted that the state and local surplus would rise even higher under both sets of proposals.'Grants to state and local governments from the federal government were undoubtedly responsible for much of the increase in expenditures, and possibly the budget surplus as well. Whereas in 1954 these grants amounted to only $2.9 billion, by 1974 they are expected to reach $41.6 billion, a thirteen-fold expansion.2 And grants are of current interest not only because of their sheer growth. The recent enactment of general revenue sharing, the administration proposal to convert existing categorical grants to special revenue sharing, and numerous other plans to federalize welfare payments or to provide property tax relief or income tax credits to state and local taxpayers-all indicate that fundamental changes are occurring in the form of federal assistance to states and localities.The increasing importance of the state and local sector and the changing role of federal grants point to the need for a more thorough understanding of the budgetary behavior of state and local governments, particularly the way in which it is influenced by intergovernmental transfers. To explore this topic, we first estimate a model of state and local fiscal behavior and then use it to examine these policy questions.We begin by discussing different forms of grant assistance and how they might ...

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This paper examines the incidence of the federal income tax exemption of interest on state and local bonds, applying a fixed-savings, simplified general equilibrium approach to estimate incidence effects on both the sources and uses of income. In contrast to traditional empirical work that allocates the benefit of tax exemption only to current holders of tax-exempt bonds based on current interest rates, we incorporate the fact that the existence of tax exemption causes the taxable interest rate to rise and the tax-exempt rate to fall. As a consequence, on the sources side, tax exemption can increase after-tax income for holders of both taxable and taxexempt bonds. On the uses side, consumers of both private and public goods are affected by the higher cost of funds to private and federal government borrowers, the lower cost of funds to state and local borrowers, and the lower cost of funds to private-sector entities with access to the proceeds of tax-exempt borrowing. Overall, higher income individuals remain the primary beneficiaries of tax exemption on the sources side with this new approach, but less so than under the traditional approach. On the uses side, households who consume a relatively large share of state and local public services, such as those with several school-age children, receive significant net benefits.

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