Nearly 30 years ago, the late professor Charles Levine and I wrote an article on the effects of austerity in which we concluded that the fiscal crisis of states and cities in the late 1970s accelerated their dependence on federal grants and an ever-growing range of accompanying mandates and requirements.

Comparing Two Recessions

Is our current Great Recession having similar centralizing effects on our federal system? How can leaders and managers in state and local governments position themselves to accept federal fiscal realities while protecting state and local prospects? We can help answer these questions by examining the similarities and differences between our current era of austerity and that of three decades ago.

Like the crises of the past, state and local governments were hit most directly and far earlier than the federal government. This reflects the differing fiscal roles played by each level of government in our federal system. While states and localities must balance their general fund, the federal government has a responsibility to balance the economy, even if it means running large deficits during the trough of a recession.

Federal aid to states and localities is one of the time-honored, and most effective, strategies available to mitigate and even reverse economic downturns. During the 1970s, the federal government provided both public works grants as well as general purpose antirecession grants to help states and localities weather the bad economy of that era. During the current recession, the 2009 American Recovery and Reinvestment Act provided over $300 billion in grants to the state and local sector in the form of general purpose relief through enhanced federal Medicaid matching as well as programmatic subsidies for education, highways and energy conservation.

In both eras, states and localities became more dependent on federal aid as a result. In the 1970s, federal public works grants drove states and localities to nearly eliminate their own capital budgets. While fiscally expedient, such a strategy can distort state and local spending priorities. Federal grants have their own priorities and mandates that may differ from those preferred by state and local taxpayers.

The dependence on federal aid in the current recession has reached greater heights than in the 1970s. Not only did the revenue shortfall for the states in particular reach historic proportions, but the size of federal countercyclical aid also set records. Many conservative governors railed against the Recovery Act and promised not to accept stimulus funds in order to avoid mandates and dependency once the federal money expired.

However, it is not clear that greater fiscal dependence entailed greater centralization. In fact, nearly $100 billion of the Recovery Act funds could be used by states for fiscal relief to support their own priorities, while local governments could use funds such as community development block grants and education grants for local priorities.

Moreover, even when the Obama administration used categorical grants as a tool to implement specific federal priorities, the implications for centralization and federalism have so far been decidedly mixed. For instance, the Race to the Top grant program in education inspired a competition for $5 billion in education reform grants which were tied to specific policy mandates such as teacher pay-for-performance standards. Unlike No Child Left Behind and other mandates, however, the competitive grant strategy allows states to opt out (as states like Texas and Virginia have done) if they don't agree with the policy direction or mandates.

Looking back, it is clear that the current economic emergency provided a brief opening to increase federal spending and grants. Following years when the real value of federal grant dollars declined, this period marked a return to a more cooperative grant-centered federalism -- a welcome break from the longer-term trend toward greater reliance on more coercive federal mandates and preemptions.

However, as the resurgent concern about deficits today illustrates, federal countercyclical spending initiatives are fleeting at best, and generally followed by a wave of fiscal remorse about the higher deficits and debt left in their wake. The federal aid of the 1970s was followed in short order by the federal retrenchment, beginning in the Carter years and accelerating during the Reagan years.

Preparing for Greater Centralization

As austerity becomes the new watchword for federal officials, the intergovernmental system will have to brace for greater centralization. What form will this take?

First, federal costs for existing programs will likely be shifted down to states and localities, but it is unclear whether they will be freed from existing federal conditions and mandates in the process. For instance, the president's commission on deficit reduction report, due Dec. 1, was presaged by a chairman's proposal which would, among many other things, cap the long-term care portion of Medicaid, forcing states to bear the brunt of containing runaway costs for nursing home care. No mention was made about removing federal mandates from the provision of that care.

Second, as federal officials come to grip with federal deficits, it is likely that new policy initiatives will take the form of regulations and mandates rather than grants which would leave states and localities with less freedom to opt out of national policies.

Third, it is likely that federal officials will reach for new revenue sources with mixed outcomes for the state and local sector. Should federal officials follow the advice of the chairman of the president's deficit reduction commission to eliminate all tax expenditures, this could broaden the base for state income tax systems that are tied to the federal tax base. However, if federal officials decide instead to adopt a value-added or other national consumption tax, this could have a direct effect on the states' sales tax revenues.

Guidelines for State and Local Leaders

The bottom line for state and local governments is that it is not a question of whether the federal government will become more demanding and less generous, but when and how. Leaders at the state and local levels need to adopt positions that accept federal fiscal realities and promote federal policy responses that do the least harm to the state and local prospects. Such positions could include the following:

  • Show a willingness to accept federal funding cuts if accompanied by grant consolidation and flexibility.
  • Demonstrate openness to greater targeting of grants to jurisdictions with the lowest fiscal resources and greatest needs, even if this means less for better-off places.
  • Explore options for states to opt out of federal standards and regulations, but with the recognition that this would entail federal officials stepping in to assume the responsibilities that states reject. The health reform is one model where states refusing to set up health insurance exchanges would prompt the federal government to do so instead.
  • Prepare to take advantage of a new national value-added tax by enabling your state to couple with or "piggyback" on the national tax base on terms that enhance state and local fiscal prospects.