Do Intergovernmental Grants Create Ratchets in State and Local Taxes?

“Nothing is so permanent as a temporary government program.” -Nobel Laureate Milton Friedman (The Yale Book of Quotations, 2006)

As the opening quote from Nobel Laureate Milton Friedman illustrates, government programs can be hard to discontinue once they are created. The many New Deal programs still in existence seem to fit into this category. In his book, Crisis and Leviathan, Higgs (1987) even proposes a ratchet theory of government growth in which temporary government programs that are enacted in response to major crisis events become permanent, thereby providing an explanation for historical government growth.  Most recently, the federal stimulus response to the financial crisis has brought about a large increase in federal government spending accompanied by a host of new government programs that may linger much longer than anticipated.

A significant amount of the recent expansion in government spending has been carried out through a major increase in federal grants to states and local governments for new ―shovelready projects. If these temporary programs are hard to eliminate in the future, their permanence will require states and localities to eventually raise their own taxes to fund these programs once the federal funds are gone. Far from always being an unintended consequence, some federal grants are made with the intention that states will pick up funding the program in the future. In 2010, for example, the city of Morgantown, West Virginia, along with 39 other cities, began receiving federal funding for the hiring of two new police officers for three years, after  which time the city will have to fund these new permanent full-time positions using own source revenue.

The general question of whether federal grants to states cause subsequent state (or local) tax increases is the topic we explore in this paper. The implications are important because if this is the case, then the recent federal fiscal stimulus should not only be predicted to cause a permanent ratchet upward in federal spending, but also a permanent ratchet in the size of state and local governments in the United States. Far from being purely an academic question, this argument is in practice why South Carolina‘s Governor Mark Sanford attempted to turn down part of the federal stimulus monies for his state. Referring to when the temporary federal stimulus funding runs out two years in the future, he states: "Who helps us then? Do we raise taxes … or do we just summarily end programs … [o]r are we to plan on yet another round of stimulus windfall from Washington in two years … The easiest of all things would be to take and simply spend all of Washington‘s well-intended stimulus efforts—but in our case it would guarantee opportunities lost that I don‘t think our state can afford."

South Carolina Governor Mark Sanford "Prudence on Stimulus in State‘s Best Interest," Myrtle Beach Sun-News, April 6, 2009.

There is a rather large literature examining how federal grants at time period t affect state or local spending (or taxes) during the same time period t (i.e., the "flypaper effect" literature). That literature asks whether federal grants tend to truly expand state spending (that is, "stick"), or whether recipients instead use some of the funding to offset current taxes or to fund other programs through reallocations of fungible resources in the period of the grant. We discuss this literature in our paper because it will be important to account for it in our empirical analysis, however, what we seek to answer in this paper is a fundamentally different question unaddressed in the current literature: How do current federal grants at time t affect state and local tax policy in the future? Our analysis attempts to answer this question using data on state revenue measures and federal grants, as well as a sample of local governments in Pennsylvania. Our results do indeed confirm the hypothesis that federal grants result in future increases in state and local taxes and own source revenue.

We will proceed as follows. Section II will discuss the reasons why temporary government programs tend to have permanence. Section III will review the literature on the "flypaper effect" because our estimation will require that we control for this in the estimation. Section IV discusses our data and presents our empirical results. Section V examines whether grants from different federal agencies tend to differ in their impact on future taxes. Section VI examines the impact of federal grants on individual tax rates and revenue sources for state governments, section VII explores the impact of federal and state grants on local own source revenue, and section VIII concludes.