The Debate We’re Not Having over Fiscal Disparities

Our state and local governments vary greatly in their capacity to address urgent public needs. Shouldn't we be talking about this issue?
by | August 13, 2014
 

It is an article of faith in public finance that the best formula for providing efficient public services is to decentralize to the lowest level of government possible. State and local governments have greater incentives to economize and improve productivity because they are, in effect, in competition with one another for taxpayers and businesses.

While the theory is alluring, competition does not play out on a neutral field. Significant disparities exist in the tax bases and needs across states and localities. A 2007 study by the Urban Institute and the Brookings Institution using the latest data on comparative fiscal capacities across states and localities showed fiscal capacity varying by nearly 120 percent between Connecticut's state and local governments and those of Mississippi. Typically, jurisdictions with low tax bases also are those with high spending needs, which together add up to a low fiscal-capacity score.

These differences have real-world consequences that are often hidden in policy debates. First, poorer jurisdictions with lower tax bases such as Mississippi would have to raise tax rates more than twice as much as jurisdictions such as Connecticut to realize the same revenue levels. But that's not all. A clear incentive is provided for wealthier businesses and citizens to move to wealthier jurisdictions to enjoy comparable or better public services with lower tax rates than poorer jurisdictions would have to levy to provide the same service levels.

This dynamic precipitates a vicious cycle, one in which the poorer places get worse while better-off jurisdictions get stronger - an all-too- familiar saga for central cities like Detroit that have witnessed the leeching of their tax bases over many decades to wealthier suburbs. While poorer jurisdictions might ultimately draw in new economic resources through lower real-estate prices, such a self-equilibrating dynamic plays out over many years, if at all.

Unfortunately, disparities in economic resources not only lead to disparate tax levels but also to highly unequal levels of public services across jurisdictions. Simply put, spending per person is lowest in places where needs are highest. As the map below shows, the areas that fall below average levels of services and above average needs are disproportionately in the South and Southwest.

Map of state fiscal disparities

Such disparities constitute a serious public-policy challenge that can undermine key national commitments and values to deliver public-policy programs to those people and places that need them the most. With renewed national debate and concern emerging about inequality from both political parties, disparities across governments is an issue that should be getting far more attention than it is.

Most federal systems establish national fiscal-equalization programs to mitigate these types of disparities and their consequences. Canada, for example, targets nearly 1 percent of its GDP to its provinces to bring their revenues up to national average levels. Australia has a grants commission which develops a detailed formula that seeks to mitigate expenditure disparities across its states.

The United States is nearly alone among major federal systems in not having such a general-purpose equalization program. This has not always been the case. In 1972, the Nixon administration gained adoption of the General Revenue Sharing program, which provided funding to all states and local governments through a mildly equalizing formula, but this was dropped in 1986.

The federal government does provide $643 billion in federal grants to state and local governments through nearly 1,000 programs. Overall, however, these funds do not significantly mitigate disparities since funding formulas are geared to other purposes.

Some grants from federal and state governments do seek to incorporate equalization principles in funding formulas. The most notable is state aid to schools where courts found that disparities undermined state constitutional equal-protection guarantees. These decisions have collectively brought about significant increases in state financing and formulas to equalize tax bases across local school districts.

Medicaid is the largest federal grant program, providing $303 billion in 2014 to the states through a formula designed to reduce disparities in states' economic resources. States with the lowest per-capita incomes get an 83 percent federal matching rate, compared to 50 percent for the wealthiest states. However, the equalizing impact of the formula is overpowered by matching requirements imposed on the states and the floor on federal matching rates for wealthier states. As a result, studies have found that Medicaid actually exacerbates disparities, as the wealthier states provide higher benefits per person than poorer states.

Were the issue of fiscal disparities to be elevated in our public debate, conceptual hurdles would have to be crossed: What service levels and economic resources would be considered to be the standard used to assess disparities? Would wealthier areas be expected to reduce their spending to finance gains by poorer areas, or would the gains be financed by other general funding sources? And there would be significant political and budgetary resistance; after all, federal grants serve the deep-seated political interest of members of Congress to return federal tax dollars to their districts.

However, progress can and has been made when equalization is seen as vital to achieving policy goals. Federal funding formulas for allocating substance-abuse and other grant funds, for example, have been reformed to promote greater equalization. And the 2009 economic-stimulus law provided new Medicaid funds using a more equalizing formula to compensate states suffering the highest impacts from the recession.

In each of these equalization "victories," illuminating the consequences of existing disparities for important policy goals was a complex task, requiring analytic input from such agencies as Government Accountability Office, the Treasury Department and think tanks such as the Urban Institute. A new intergovernmental fiscal institution along the lines of the old Advisory Commission on Intergovernmental Relations could provide the needed data and support to elevate these issues to front-burner standing on a crowded national agenda.

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