| September 6, 2011
Federal Grants and Unintended Consequences
Ever since the New Deal, state and local governments have increasingly accepted the idea that the federal government should be in the business of providing aid, such as disaster relief. Fast forward 80 years, and Uncle Sam is now providing “aid” in areas such as health care, education, housing, and even elections, just to name a few.
Today, state and local governments pursue federal dollars because they are viewed as “free money.” This frees state and local politicians from having to increase taxes or reduce other spending in order to fund their pet projects. However, federal money not only comes with strings attached, but can even induce higher state and local government spending. This article will show the extent to which Oklahoma already depends on Uncle Sam’s money, and will estimate how much extra taxation Oklahomans now pay because of this aid.
The data used in this analysis are from a report called “Federal Aid to the States” published by the U.S. Census Bureau.1 Chart 1 shows the inflation-adjusted (real) per capita federal aid flowing into Oklahoma between Fiscal Year (FY) 1995 (the earliest year of available data) and FY 2009 (the latest year of available data). Federal aid into Oklahoma grew twice as fast as the national average (87 percent versus 39 percent, respectively). As a result, Oklahoma went from being below the national average to above it in FY 2009. -
In Federal Fiscal Year (FFY) 2009, Oklahoma had the 15th highest level of federal aid in the country—or $2,103 for every man, woman, and child. Regionally, only New Mexico had a higher level of federal aid ($3,260) than Oklahoma. The other surrounding states are much less dependent: Colorado ($1,277, rank 47th), Kansas ($1,397, rank 45th), Texas ($1,429, rank 44th), Missouri (1,730, rank 24th), and Arkansas ($1,936, rank 17th).
To shed light on where all this federal aid goes, Table 1 breaks down aid by agency for FY 2009. Overall, Uncle Sam sent $552,108,118,000 in aid to the states, of which $7,828,070,000 went to Oklahoma. Nearly 60 percent of that aid, both nationally and in Oklahoma, comes from a single agency—the Department of Health and Human Services (DHHS). Of the $324,765,262,000 spend by DHHS ($4,580,511,000 in Oklahoma), 79 percent (68 percent in Oklahoma) goes to Medicaid. Of course, other federal agencies send significant aid to Oklahoma as well.
However, one problem with all of this federal aid is that, according to new evidence, it induces higher state and local taxes. A recent study by Russell S. Sobel and George R. Crowley (West Virginia University) succinctly states:2
Federal grants often result in states creating new programs and hiring new employees, and when the federal funding for that specific purpose is discontinued, these new state programs must either be discontinued or financed through increases in state own-source taxes. Government programs tend to be difficult to cut, as goes Milton Friedman’s famous quote about nothing being as permanent as a temporary government program, suggesting it is likely that temporary federal grants create permanent (future) ratchets in state taxes. Far from being a purely academic question, this argument is in practice why South Carolina’s Governor Mark Sanford attempted to turn down federal stimulus monies for his state.
In a nutshell, Sobel and Crowley found that federal grants today will increase future state taxes by between 33 and 42 cents for every grant dollar, while local taxes will rise between 23 and 46 cents for every grant dollar. By taking the median value for both, the state and local government estimate yields an overall future increase of 40 cents for every dollar of federal grant money.
To put this into perspective, between FY 1995 and FY 2009, federal grants to Oklahoma increased by $5.4 billion—to $7.8 billion in FY 2009 from $2.5 billion in FY 1995. As a result, Oklahoma’s state and local tax burden would also increase by approximately $2.1 billion.
Over the same time period, data from the U.S. Census Bureau show that Oklahoma’s state and local government expenditures increased by $16.7 billion—to $30 billion in FY 2009 from $13.2 billion in FY 1995.3 Without the increase in federal grants, state and local expenditures could have been 12.6 percent lower in FY 2009 ($2.1 billion in higher state and local government spending due to federal grants divided by $16.7 billion increase in state and local spending). This $2.1 billion would have been enough money to completely eliminate the state sales tax, or nearly eliminate the state individual income tax.
Of course, it’s not just the federal government that likes to dole out grants. State governments often provide grants to their local governments, and the study found that $100 in state grants eventually raises local government taxes by between $23 and $46.
In short, there is no such thing as “free money” from Uncle Sam. There are unintended consequences that result from the massive transfer of funds from the federal government to state and local governments.
Economists J. Scott Moody (M.A., George Mason University) and Wendy P. Warcholik (Ph.D., George Mason University) are OCPA research fellows.
1 The report can be found at http://www.census.gov/govs/cffr/
2 Sobel, Russell S. and Crowley, George R., “Do Intergovernmental Grants Create Ratchets in State and Local Taxes? Testing the Friedman-Sanford Hypothesis,” Mercatus Center, George Mason University, Working Paper No. 10-51, August 2010. http://bit.ly/bUxGeN
3 Local expenditures for FY 2009 were estimated by the authors. Government expenditure data can be found at http://www.census.gov/govs/estimate/#sthash.wnSX9l13.dpuf