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Do intergovernmental grants create ratchets in state and local taxes?

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Abstract

A large literature on the ‘flypaper effect’ examines how federal grants to states at time period t affect state spending (or taxes) at time period t. We explore the fundamentally different question of how federal grants at time period t affect state tax policy in the future. Federal grants often result in states creating new programs and hiring new employees, and when the federal funding 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 that it is likely that temporary federal grants create permanent (future) ratchets in state taxes. Far from being purely an academic question, this argument is why South Carolina’s Governor Mark Sanford attempted to turn down federal stimulus monies for his state. We examine both the impact of federal grants on future state budgets and how federal and state grants affect future local government budgets. Our findings confirm that grants indeed result in future state and local tax increases of roughly 40 cents for every dollar in grant money received in prior years.

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Notes

  1. The original Friedman quote appears both in the October 27th, 2993 issue of the Cleveland Plain Dealer and in the book he coauthored with his wife Rose D. Friedman, Tyranny of the Status Quo (Harourt Brace Jovanovich, San Diego, CA, 1984, pg. 115). Variants of this quote have also been attributed to President Ronald Reagan and Utah Senator Wallace F. Bennett. Reagan’s quote is “We have long since discovered that nothing lasts longer than a temporary government program,” appearing in Ronald Reagan: The Great Communicator (Harper Perennial, New York, NY, 2001, pg. 59). Bennett’s quote is “It is an age-old Washington axiom that there is nothing so permanent as a temporary government program,” appearing (somewhat ironically given the topic of our paper) in a government committee review of federal grants to states (Periodic Congressional Review of Federal Grants-in-aid, published by United States Congress, Senate, Committee on Government Operations, 1964, pg. 15).

  2. See Higgs (1987), Chap. 8, for a discussion of the many remaining ‘institutional legacies’ of the New Deal programs.

  3. The ‘leviathan’ model of government is one that assumes the objective of government is to maximize its size, see Brennan and Buchanan (1977, 1978, 1980).

  4. For evidence that political factors influenced the allocation of stimulus funds in the recent American Recovery and Reinvestment Act see Young and Sobel (2011).

  5. For evidence that this problem is inherent in the U.S. constitutional structure, see Holcombe (1991, 1992).

  6. In this section we provide only a brief summary of the main arguments in this rather large literature. See Hines and Thaler (1995) and Bailey and Connolly (1998) for excellent overviews and summaries of this large empirical literature and the theoretical expectations.

  7. Nearly all states operate under some sort of balanced budget rule. As such, an analysis of state revenues (as we carry our here) is essentially the same as an analysis which uses state expenditures.

  8. We experimented with the inclusion of state-specific time trends in addition to our fixed effects. Our results (presented in Appendix 3) did not change in any meaningful way.

  9. A panel unit root test confirmed that our dependent variable is stationary, thus we carry out our analysis in levels.

  10. We have adjusted for the difference between federal and state fiscal years in the data by pre-lagging federal funds by one year.

  11. More formally, VIF statistics show a very high level of multicollinearity amongst our variables in all of our models containing lags.

  12. Both the AIC and BIC statistics indicate that our specifications with five lags are preferred to those with fewer lags.

  13. One can back out the implied flypaper effect coefficients (on spending) from our regressions (on taxes) for comparison with previous literature by calculating 1−β 1, which is 0.2357 in the final specification.

  14. Specifically, we multiply each state’s electoral votes by one minus the percentage margin of victory. In other words, for a given set of electoral votes states characterized by closer contests are given more weight.

  15. Percentages are for federal grants to state and local governments for federal fiscal year 2008.

  16. We thank the editor for this insight.

  17. Regressions using the top marginal tax rate as the dependent variable yielded insignificant results. Importantly, income tax revenues can be increased in a variety of ways other than changing the top marginal tax rate, including manipulation of deductions, exemptions, and tax brackets. Given our significant findings using income tax revenue, the results suggest one (or some combination) of these alternative mechanisms is being used to raise future revenue in response to the federal grant.

  18. In theory, the maximum coefficient on the current period is one, and in the table some of the coefficients are greater than one; however, none of these are significantly different from one at traditional levels.

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Acknowledgements

We thank Thomas Stratmann, Richard Williams, the participants at the 2011 Southern Economic Association meetings in Washington, DC, the editor of this journal, and two anonymous referees for helpful comments and suggestions, and also gratefully acknowledge the financial support of the Mercatus Center.

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Authors and Affiliations

  1. Department of Economics & Finance, School of Business, College of Charleston, 66 George Street, Charleston, SC, 29424, USA

    Russell S. Sobel

  2. Manuel H. Johnson Center for Political Economy, Sorrell College of Business, Troy University, Troy, AL, 36082, USA

    George R. Crowley

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  1. Russell S. Sobel
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  2. George R. Crowley
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Correspondence to George R. Crowley.

Appendices

Appendix 1: Variable descriptions and data sources

figure a

Appendix 2: Statistical significance of individual lags

figure b

Appendix 3: Primary specification including state-specific year trends

figure c

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Sobel, R.S., Crowley, G.R. Do intergovernmental grants create ratchets in state and local taxes?. Public Choice 158, 167–187 (2014). https://doi.org/10.1007/s11127-012-9957-5

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