Save the States: How Should the Federal Government "Help" Struggling State and Local Governments?

by Neil H. Buchanan 
One of the best bits of below-the-radar news recently is that the COVID relief bill contains $350 billion in direct aid for state and local governments.  That bill is not a law yet, but it should soon pass the House and make its way to the Rose Garden for a signing ceremony later this week.  The one-time $1400 checks and extended unemployment benefits have received most of the attention -- along with what was not in the final bill: a minimum wage increase -- and rightly so, but the sub-federal aid was an essential part of the package.
And the news is even better for state and local governments, because the bill also includes money to support local capital projects that would otherwise have been cut.  Moreover, with the Biden-led federal government now actually taking on pandemic-related responsibilities that had fallen to ill-funded states and cities under the Trump Administration's denialist approach, those governments will simultaneously receive direct funds and be relieved from continuing to make expenditures that they could not afford.  Add in the general economic boom that the bill will ignite, and state and local comptrollers everywhere must be feeling something other than panic for the first time in a year.

Am I -- from my perspective as an employee of a state government -- viewing this too parochially?  That cannot be right, because I hold the same views now about state/local finance that I did during the decades in which I worked at private universities; so this is hardly a foxhole conversion.  The fact is that states and cities are in need of aid, and the Democrats are finally giving it to them.

But what is the "right" approach to what econo-nerds call fiscal federalism?  Should the federal government be giving the states and cities any money at all?  If so, how should it determine the amounts to go to each state?  What is fair?
In the title of this column, I put scare-quotes around the word "help" in asking how the feds should help non-federal governments.  I did so because it is not actually meaningful to describe what the federal government is doing as matter of "just helping out in a crisis."  The federal fiscal system is part of the whole system that includes all levels of government.
The fact is that fiscal policy is only coherent when looked at as a national whole (at least), and the arbitrary state lines that Eighteenth- and Nineteenth-century colonialists and surveyors drew should be ignored as much as possible.  Rather than "helping" non-federal governments, we must think of the federal government as the largest piece of a multi-piece puzzle.  What matters is people, not state and city boundaries.

I have been thinking about these issues recently because I received an inquiry from a reporter for a finance website, who wanted to know how to think about different states' dependence on federal funds.  He asked for my responses to the following fundamental questions:
  • Should federal resources be allocated to states according to how much they pay in federal taxes, or should some states subsidize others?
  • Which programs should be a state/local responsibility and which should be a federal responsibility?
  • What is the most fair way to redistribute federal resources back to the states?
  • What more can the current administration do to help reduce the impact of revenue shortfall in state budgets during this economic downturn?
Rather than limit myself to a quick email response -- and because these questions are of great importance more generally -- I decided to respond by writing this column.  I will not address the questions one at a time, but I will use them below to focus on particular issues.

The American Recovery Plan's relief for state and local governments would be great news no matter what, but it is even more important as a response to a bad situation that became worse when the Senate's now-Minority Leader Mitch McConnell blocked state and local fiscal aid in 2020.  He coined the term "blue state bailout," sneeringly saying that the problem is that profligate liberals in places like New York and California were looking for a handout from the federal government.

Joining a chorus of objections from the reality-based community, I responded to McConnell's claims in a two-part column on Verdict (here and here).  I pointed out -- among many other things -- that in fact the states with more liberal governments subsidize states with more conservative governments.  That is, mostly red states receive more money back from the federal government than they pay, and mostly blue states pay the federal government more money than they receive.  That is a persistent pattern, long predating the pandemic.

So having the federal government finally step forward now and help all states -- red, blue, and purple -- was an important political accomplishment for President Biden and the Democrats, overcoming Republicans' fearmongering about purportedly frivolous state governments.  Nonetheless, an article in The New York Times on March 1 temporarily confused matters by reporting that only a few states had lost large amounts of revenue due to the pandemic.  The only states that lost more than 10 percent of revenues from April through December 2020 (compared to the same period in the previous year) were Alaska, Hawaii, North Dakota, Nevada, Florida, Oregon, and Texas.  Twenty-one states lost smaller amounts, and twenty-two states actually saw revenues increase.

Even so, that analysis was wholly incomplete in not also showing the increases in expenditures that had been forced upon the states, with the states' fiscal battering resulting in well over a million layoffs of state and municipal employees -- police, firefighters, teachers, and other essential workers.  The point is that, even though the effects on particular state governments will of course vary, the biggest health and economic crisis in generations was of course going to hammer government finances at every level.

Returning to the questions above, the easiest to answer in our current situation is the third one: "What is the most fair way to redistribute federal resources back to the states?"  As I pointed out in my Verdict columns, it would be straightforward to "make the states whole" by having the federal government fill the state's operating deficits.  That is relatively easy to determine, because almost every state must balance its operating budget (which most definitely does not mean that states never borrow money, because borrowing is how they finance their long-term investment projects).

Even so, that does not quite capture the full picture, because the state and city governments that laid off workers spent less money by cutting essential services.  That means that some states ended up with smaller operating deficits, even though the states' citizens suffered by living with a government that could not continue to provide even the same level of services as before, much less the enhanced services needed during a pandemic.  The people's sacrifices do not show up in their state's operating deficit.
The last of the four questions above -- "What more can the current administration do to help reduce the impact of revenue shortfall in state budgets during this economic downturn?" -- is thus an important one.  The best approach would be for the federal government to send grants to states that would allow the states to mitigate the damages that they suffered, whether or not those damages showed up directly in state deficits.  Rather than following the Republicans' strategy of using a crisis to punish states, we should have the federal government make states whole by restoring their finances to where they would otherwise have been.  The pandemic was a national crisis (actually a global one, but that is beyond the scope of this discussion), so there is no reason that the costs should be borne unequally from city to city and state to state.

At the very least, then, we should use the federal government's ability to borrow at bargain-basement rates to put states and cities in the best fiscal shape possible, essentially saying that the entire cost of the pandemic should be carried by the national government.  And that shines a useful light on the first question above: "Should federal resources be allocated to states according to how much they pay in federal taxes, or should some states subsidize others?"  Certainly, there is no reason to think that states and cities will suffer in proportion to their federal taxes, so that is a poor guide indeed to how the federal government should proceed.

Moreover, it is absurd to think that the federal government should make sure that each state's total federal payments are exactly equal to the federal money that the state receives.  After all, we are not tracking money that a state's government is paying to the feds and comparing that total to what it receives from Washington.  We are looking at the net payments of the state's citizens -- who are, of course, also American citizens -- to the federal government, and there is no reason to think that the needs of every state's citizenry are going to be equal to all others.

After all, if a state has a large number of retirees, then large amounts of federal money will flow into the state in the form of Medicare and Social Security payments.  Why in the world would we then say that the state's non-retired citizens must pay more in federal taxes to balance that out?  If there is a devastating tornado in the Plains states, would we tie federal disaster aid to amounts of money that the citizens of that state pay to the federal government?  Should a state with a large cancer cluster -- caused, perhaps, by an ethnicity-specific genetic abnormality that happens to be concentrated in one state -- be on the hook to pay more federal taxes?

The point of having a federal government with any fiscal powers at all is to make it unnecessary to determine which states deserve punishment or praise.  When we decide that "the government" should, say, subsidize child-rearing, we recognize that states with higher birthrates will receive more money.  And when we set up a federal income tax system to be progressive -- that is, to collect proportionately more money from higher-income people than from lower-income people -- we know that states like Connecticut, New York, and Maryland will pay more, because those states are home to more rich people than other states.  Those higher federal tax payments should not entitle those rich states to, say, more defense spending or agricultural subsidies.

All of this brings us back to the remaining question from above: "Which programs should be a state/local responsibility and which should be a federal responsibility?"  That is an important question, but it is crucially different from the others.  The state-versus-federal balance, as I have argued, is a nonsensical way to frame the debate.  We should simply not care whether some states end up paying more per capita to the feds than other states do.  That entire inquiry is a red herring.

How to split up government responsibilities within a federal system, however, is anything but a distraction.  If the people who happen to live within a state's boundaries are poorer on average than the people in other states -- assuming that we are running a humane country -- they will pay fewer taxes and receive more benefits than other states.  But does it matter whether those taxes and benefits are collected and administered at the federal level, rather than at the state level?

It should not matter at all, because we should simply choose the level of government on the basis of relative expertise.  That is, if it turns out that cities are (or can be) very good at doing one thing, while the states and the federal government are better at other tasks, then we would want to divide the efforts of the government sector accordingly.

There are, however, few tasks that are obviously provided better by one level of government than another.  National defense seems the most obvious example of something that the federal government could handle best.  On the other hand, what in America has been among the quintessential local government duties -- K-12 education -- is in many ways a disaster precisely because it is financed and managed at the local level.  The other big local task, law enforcement, is similarly a mess.

New Jersey is infamous for having a huge number of tiny local governments, almost all of which have their own police forces and municipal services.  That is almost surely a huge waste, with far too many resources being used to replicate services that could be provided more effectively on a larger scale.  The problem is that scaling up exactly to the state level is not at all the obvious goal, again because state boundaries are historical accidents.  (I can explain, for example, why the Upper Peninsula is part of Michigan and not Wisconsin, but an explanation is not a justification.)

Question: "Should this be a federal, state, or local responsibility?"  Answer: "It depends, but there is no reason to presume that the right answer will ever be the state level."  At least the boundaries of cities are less arbitrary, but only marginally so.  For example, Columbus is the most populous city in Ohio, but the Cleveland and Cincinnati areas are almost identical in size to Columbus's.  (And this is not limited to the U.S.  See, e.g., "The City" of London)
This is not to forget the race to the bottom, in which an otherwise sensible decision to have a state provide a service does not necessarily mean that the state should raise the money to pay for it.  A discussion of migration effects due to taxes is beyond my scope here, but suffice it to say that we could -- indeed, we often do -- have the federal government collect the revenues that the states and cities spend.

In the end, although choosing among the levels of government can be very consequential, it is simply not possible to answer that question generally.  Indeed, we could even do away with state governments altogether, allowing city governments to continue to operate and interact fiscally with the federal government.  Even though we have come to rely on the historical oddities that we call states for many things, there is nothing sacrosanct about any of it.

The federal government must thus "help" state and local governments when a crisis arises, not out of the goodness of its heart but because our mix of services among the levels of government is arbitrary.  U.S. citizens' lives and well-being are at stake, and it is ultimately the responsibility of the U.S. government to fix what cannot be done by the states or the cities.  Putting arbitrary limits on the federal response only makes it harder to solve real problems.