State and Local Fiscal Behavior and Federal Grant Policy

Abstract

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comments of several members of the Brookings panel, and also from discussions with Frank de Leeuw, has supplied us with unpublished national income accounts data, Joseph Valenza ably assisted with the computer work, Su Nokkeo with data preparation, and Kathryn Breen and Patricia Sachs with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 ...

Catalytic effect of capital transfers in a federal context: the case of Spanish regions

“…Thus, equalization transfers and other redistributive subsidies can influence the policies of recipient governments in the intended direction, i.e., resulting in the desired incentive effects, but may also induce adverse or undesirable incentive effects Smart, 2002 andRego, 2002). If the income elasticity of capital expenditure is greater than 1, when it receives the transfer the receiving government will take funds from current spending to allocate to investment (Bradford andOates, 1971 andGramlich et al, 1973). If the receiving governments are required to co-finance a percentage of the subsidised capital goods (compensatory transfers or matching grants), the donor and receiving administrations will share the investment cost, reducing the price of capital expenditure for the receiver.…”

“…As Gramlich et al (1973) and Oates (1999) point out, standard theory leaves little room to explain the existence of both categorical block grants (i.e., flat-rate subsidies that have to be used for certain specific purposes), and closed-ended matching grants (i.e. transfers that subsidize the costs of specific goods with a fixed maximum amount).…”

“…They may also have an asymmetric response in the jurisdictions, depending both on the relative importance of the stimulus involved in the transfer for each jurisdiction, and on their disparate socio-economic conditions and their changes in time, and provoke other effects, such as geographical and displacement effects. There is, therefore, a broad consensus on the need to reinforce empirical attempts to assess the effectiveness of these policies on the objectives pursued, and the existence of unintentional distorting impacts (Gramlich et al, 1973, Dahlby 2002, Buettner, 2006, Karkazis and Thanassoulis, 1998, Brun and Khdari, 2016, and Del Bo and Sirtori, 2016. This paper proposes an empirical exercise to quantify the stimulus effect of conditional capital transfers from higher levels of government on investment in regions.…”

Unsticking the Flypaper Effect Using Distortionary Taxation

“…A second group holds that omitted variables could also falsely support the flypaper effect if unobserved community"s characteristics, which affect the technology or effective cost of public spending, were systematically related with citizens" income (Hamilton, 1983). The flypaper puzzle, however, remains after using truly unconditional grants (Inman, 1971;Gramlich and Galper, 1973;Bowman, 1974) or controlling for population characteristics. A third group holds that the standard model of a citizen"s fiscal choice might be misspecified because either the citizen confuses the income effect generated by unconditional transfers with a price effect that reduces the average effective cost of public spending (Courant et al, 1979;Oates, 1979), he/she is not fully informed and fails to see the public budget (Filimon et al, 1982) or, even when fully informed, he/she might not behave completely rationally (Hinesand Thaler, 1995).…”

Untitled

“…There appears to be strong empirical evidence in support of greater impact on local public spending from an increase in grants than from an equivalent increase in residential income. This regularity was called the "flypaper effect" by Gramlich and Galper (1973). Although the median voter models can be modified to account for flypaper effects, it appears rather artificial to allow for different tax and spending responses of grants-in-aid and residential income when the median voter is considered to be the decision-maker.…”