Effects of the Federal Stimulus on State & Local Governments

Effects of the Federal Stimulus on State & Local Governments

This section assesses the consequences of the American Recovery and Reinvestment Act of 2009 (stimulus) for individual freedom, as affected by state and local policies. While the stimulus was passed immediately after the period covered by this study, we can use findings on the effects of federal grants on state policies to infer what the long-run consequences of the stimulus will be.

Title V of the stimulus provided for “state fiscal relief” in the amount of $144 billion, the majority of which was dedicated to shoring up Medicaid, with most of the remainder going to education. The purpose of the Medicaid funding was to forestall cuts to the program by state governments, since state governments have to match federal funding. Likewise, the education grants were meant to prevent teacher layoffs and encourage school modernization.40 Thus, the effect of the stimulus went beyond the headline number to encourage state governments to spend more from their own resources. This aspect of the program in the short term causes fiscal freedom as we measure it to fall below what it would otherwise have been. Of course, one might argue that this increase in the size of government (and corresponding reduction in individual freedom) was justified given the circumstances. We do not address this question here. However, a more interesting question is whether the stimulus’s effects will be purely short term, or whether we can expect longer-term consequences for state and local budgets, as states may decide to continue stimulus-funded programs with own-source revenues.

We start with some anecdotal evidence. In our survey of SPN policy analysts, we asked a question about the effects of the stimulus on state taxes and spending. A respondent from a Rocky Mountain state reported that stimulus funding made up 10 percent of the baseline budget in FY 2010, to be carried into future years. A Pacific Northwest state analyst cited strict maintenance-of-effort requirements as contributing to less-efficient state administration and noted that the legislature passed a significant tax hike in order to support continued state spending at stimulus levels.41 All 23 respondents who replied to this question said the stimulus permitted increases in state spending; in no case did the stimulus allow states to offset tax cuts.

However, these respondents may be predisposed to oppose federal grants to state governments and the stimulus bill; moreover, not enough time has passed to assess the long-term consequences of the stimulus specifically. Therefore, it is worth looking at broader data to see whether federal grants really do encourage long-term increases in state taxes and spending. Sobel and Crowley test whether federal grants increase state and local taxes beyond the year in which they are awarded.42 They regress state and local tax revenues and own-source revenues (including nontax revenues) on same-period and lagged federal grants simultaneously to control for the short-run “flypaper” effect. They find that federal grants do cause states to enact own-source funding of programs once federal funds disappear. Specifically, every additional dollar in federal grants stimulates a permanent increase in state and local taxes or revenues of 33–42 cents.

We take the lower-bound estimate and use it to interpret the long-run effect of the federal stimulus. We expect state and local taxes to increase $47.5 billion in the long run as a result of the stimulus, which is about $950 million per state or 0.4 percent of national personal income, excluding the District of Columbia. To put that amount in perspective, the average state and local taxation as a percentage of personal income in FY 2008 was 10.1 percent, and the standard deviation was 1.2 percent. Therefore, the adverse long-term effect of the stimulus should be noticeable but not enormous.


Footnotes

40. U.S. Department of Education, “State Fiscal Stabilization Fund,” http://www2.ed.gov/policy/gen/leg/recovery/factsheet/stabilizationfund.html.

41. We are vague about these states’ identities in order to protect the anonymity of respondents.

42. Russell Sobel and George R. Crowley, “Do Intergovernmental Grants Create Ratchets in State and Local Taxes?” Mercatus Research Summaries (Arlington, VA: Mercatus Center at George Mason University, September 17, 2010), http://mercatus.org/sites/default/files/publication/Do%20Intergovernmental%20Grants%20Create%20Ratchets.WP_.Corrected.10.4.10_0.pdf.

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