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Impact of Federal Transfers on State and Local Own Source Spending

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A large amount of economic research has examined the impact of federal grants on state and local spending. Much of this previous research, however, has focused exclusively on the impact of federal grants on total state and local spending itself rather than on the extent to which federal grants drive additional state and local spending and, in turn, drive demand for higher state and local taxes, fees, and other own-source revenues. Our study departs from earlier literature by examining the impact of federal transfers on state and local taxes and fees. This is the most comprehensive analysis to date, using information from U.S. states spanning the period from 1972 to 2012. Our results clearly demonstrate that federal transfers to state and local governments result in higher own-source revenue, taxes, and fees. Regression results indicate that state and local revenues from taxes, fees, and other own-sources will rise by 82 cents for each additional dollar in federal transfers. A hypothetical 10 percent increase in federal transfers would amount to about $62 billion to the states. Using our regression results, and holding personal income constant, this would be associated with approximately $50 billion in additional increased taxes, charges, or from other revenue sources, resulting an additional government burden of $158 per person.
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Impact of Federal Transfers on State and Local Own-Source Spending 1
1 Impact of Federal Transfers on State and Local Own-Source Spending
Eric Fruits, Ph.D.
Economics International Corp.
IMPACT OF FEDERAL
TRANSFERS ON STATE
AND LOCAL OWN-
SOURCE SPENDING
November 2015
2 Impact of Federal Transfers on State and Local Own-Source Spending
Impact of Federal Transfers on State and Local Own-Source Spending 3
2 Impact of Federal Transfers on State and Local Own-Source Spending
Executive Summary
A large amount of economic research has exam-
ined the impact of federal grants on state and local
spending. Much of this previous research, however,
has focused exclusively on the impact of federal
grants on total state and local spending itself rather
than on the extent to which federal grants drive ad-
ditional state and local spending and, in turn, drive
demand for higher state and local taxes, fees, and
other own-source revenues. Our study departs
from earlier literature by examining the impact of
federal transfers on state and local taxes and fees.
This is the most comprehensive analysis to date,
using information from U.S. states spanning the pe-
riod from 1972 to 2012.
Our results clearly demonstrate that federal trans-
fers to state and local governments result in higher
own-source revenue, taxes, and fees.
Regression results indicate that state and local
revenues from taxes, fees, and other own-sources
will rise by 82 cents for each additional dollar in
federal transfers.
Graphical analysis supports the statistical analy-
sis and suggest that each additional dollar in fed-
eral transfers is associated with an increase in
state and local taxes and fees of 74–88 cents.
Recent peer-reviewed research published in the
widely cited academic journal Public Choice sup-

of additional federal grants to states is associated
with a total increase of 54–86 cents in new state
and local taxes.
Federal transfers to states have grown from $74 bil-
lion a year in 1980 to almost $300 billion in 2012.
Based on our results, state revenues from taxes,
charges, and other own-sources will rise by 82
cents for each additional dollar in federal transfers.
A hypothetical 10 percent increase in federal trans-
fers would amount to about $62 billion to the states.
Using our regression results, and holding personal
income constant, this would be associated with
approximately $50 billion in additional increased
taxes, charges or other revenue sources, or an ad-
ditional government burden of $158 per person.
Importantly, our results suggest that the increases
in federal grants to state and local governments
associated with the ACA’s Medicaid expansion will

and local level as these governments raise revenue
to continue, expand, and promote these newly fund-
ed programs into the future and as federal support
tapers off once the expansion is in place.
IMPACT OF FEDERAL
TRANSFERS ON STATE
AND LOCAL OWN-
SOURCE SPENDING
4 Impact of Federal Transfers on State and Local Own-Source Spending
I. Introduction
     
state and local government spending? This has
       
experiment with revenue sharing, nearly 200
years ago. In 1835, the federal government enjoyed
a budget surplus. In addition, forecasts at the time
projected federal surpluses into the foreseeable
future. Congress decided to distribute the surplus
to the state governments, based on population.
The thinking was that states would use the money
to fund additional public works. In other words,
it was expected that state governments would
use the grants they received from the federal
government to increase state and local spending,
without increasing state and local taxes.
Federal intergovernmental transfers—usually
        
state and local budgets (hereafter, unless stated
otherwise, “states” should be understood to include

grant was made under the Hatch Act of 1887. The
Act is still in effect and more than $56 million was
distributed to states in 2014 under the Act. By 1980,
federal transfers to states had grown to $74 billion
a year. By 2012, these transfers grew to almost $300
billion a year. In 1980, federal transfers amounted
to about 3.2 percent of total personal income. By
2012, the amount had grown to 4.2 percent of total
personal income.
The stimulus package known as the American
Recovery and Reinvestment Act, enacted during the
recession of 2008–2009, revived interest in the effects
of federal intergovernmental transfers on state and
local budgets and raised the following questions:
Does temporary state and local spending induced
by federal grants disappear from state and local
budgets when grant provisions expire; or
Do federal grants have a lasting effect on state
budgets, with temporary aid giving rise to permanent
state expenditure programs that ultimately require
increased state and local revenue?
Indeed, concerns about a “ratchet” effect on state
budgets were cited by several state lawmakers
who considered refusing stimulus money from the
federal government. For example, in early 2009,
Louisiana’s Governor Jindal issued a statement
saying Louisiana would not participate in a federal
stimulus program aimed at expanding state
unemployment insurance coverage.
Most federal grant programs are small and serve
narrow purposes. A few large programs, however,
such as Medicaid and the Highway Planning and
Construction program, dominate the grant-in-
aid system.
Looking forward, implementation of the Affordable
Care Act is raising the issue of the extent to which the
Medicaid expansion provisions will affect state and
local taxes in those states that opt to expand Medicaid
coverage. As enacted, the Affordable Care Act
broadened Medicaid’s reach to include nearly all low-
income Americans with incomes up to 138 percent
of the federal poverty level. A Supreme Court ruling
on the ACA gave states the option of implementing
the Medicaid expansion. For states that expand, the
federal government will pay 100 percent of Medicaid
costs of those newly eligible for Medicaid from 2014
to 2016. The federal share gradually phases down to
90 percent in 2020. In 2013, Medicaid accounted for
15.1 percent of spending from state general funds
and other non-federal amounts that are not a part
Impact of Federal Transfers on State and Local Own-Source Spending 5
4 Impact of Federal Transfers on State and Local Own-Source Spending
of general funds, such as provider taxes levied for
     
place substantial burdens on state budgets—even
with federal funds covering 90 percent of the costs
of expansion. This raises the question whether states
will divert spending from other programs or increase
taxes to fund the states’ share of the increased costs
of Medicaid expansion.
Federal grants are expected to serve purposes
beyond returning resources to taxpayers in the
form of state and local services. It is argued that
grant programs encourage states to spend federal
funds on activities, projects, and services for which
they otherwise would have spent less. The amount
of additional spending is affected by the degree to
which federal grant funds encourage more or less
spending from states’ own-sources.
Figure 1. Illustrative impacts of $2 in federal grants on state
spending from state and local revenues
Conceptually, the impact of federal transfers on state
and local budgets is ambiguous. Theory indicates
that state and local spending could grow, shrink, or
stay the same, depending on how state and local
governments respond to the additional federal funds:
1. Federal funds crowd-out state funds on a dollar-
for-dollar basis. State services remain a pre-
grant levels. As shown in the second bar in
Figure 1, the federal funds replace state own-
source funding (e.g., funds from taxes, fees, and
other state and local sources). In this way state
spending from own-source revenues declines,
and is ultimately returned to residents through
lower taxes or reduced fees. Because federal
funds replace state own-source funds dollar-for-
dollar, the federal spending is said to crowd out
state and local spending.
6 Impact of Federal Transfers on State and Local Own-Source Spending
1 Hines and aler (1995).
2 Wrightson et al. (1996).
2. Federal funds fully supplement state funds. As
shown in the third bar in Figure 1, federal funds
are added on top of state own-source funding.
In this way state spending from own-source
revenues is unchanged, but total state spending
increases. This result is widely known as the
       
who remarked that the money the government
sends out “sticks where it hits.
3. Federal funds stimulate state spending. As shown
in the fourth bar in Figure 1, federal funds are
added on top of state own-source funding and
stimulate additional state spending. A review of

spending is stimulated by much more than theory
would predict. A review of numerous studies—
done with a variety of approaches and data

federal grants increases the spending of state or
local agencies by 25 cents.1
at the high end, federal grants stimulate a dollar-
for-dollar increase in state or local spending.
    

grants can increase state spending: (1) matching
fund requirements, and (2) maintenance of effort
requirements.2
Many federal grants require that state or local
governments contribute their own funds in order
to receive federal matching funds. Economic theory
suggests that grants requiring matching funds result
in less substitution than those that do not require
matching. It is argued that, by lowering the effective
price of aided programs relative to other state
spending priorities, they encourage states to spend
more of their own funds. Matching requirements
may stimulate state spending by encouraging states
to engage in and fund projects or deliver and fund
services that they would not undertake without the
matching funds. For example, consider a hypothetical
light-rail transportation project with a $200 million
construction cost and requiring a $5 million a year
subsidy for operations. The local government would
not go forward with the project at $200 million in
construction costs. However, with a federal matching
funds, the locality’s share of constructions are $100
million, and the local government chooses to move
forward with the project. Because of the federal
matching funds, the locality is burdened with an
additional $100 million in spending for construction,
plus an additional $5 million in operating costs
that would not be incurred if the project had been
rejected. These additional funds must come from
existing programs or additional revenues in the form
of taxes, fees, or charges.
Maintenance-of-effort requirements demand states
maintain existing levels of state spending on an
aided program as a condition of receiving federal
funds. By requiring states to maintain a given level
of spending from their own funds in addition to the
federal grant funds they receive, maintenance-of-
effort can prevent substitution in those programs
where there is no federal matching requirement
or where state spending exceeds the minimum
required state match. For example, the American
Reinvestment and Recovery Act—more commonly
known as the “stimulus package”—had a provision
that required states to provide a minimum threshold
state appropriation to higher education of not less
than the 2006 state appropriated levels. States
falling under the maintenance-of-effort threshold
       
stimulus money. A publication of the American
Association of University Professors concludes that
state appropriations data clearly show that the
Impact of Federal Transfers on State and Local Own-Source Spending 7
6 Impact of Federal Transfers on State and Local Own-Source Spending
threat of loss of federal funds was the key driver
of higher education budgeting decisions for many
states.3 For example, for 2010, Oregon matched the
federal threshold amount precisely. Nearly a dozen
other states came in just over the minimum in 2010.
In this way, maintenance-of-effort requirements
caused states to spend more on higher education
in the wake of the Great Recession and shrinking
state budgets than they would have otherwise. This
in turn, led to pressures to raise taxes. For example,
in 2010 the Oregon legislature referred—and voters
approved—two tax measures amounting to a $727
million state tax increase.
In addition to the strings attached to federal funds,
research points to a “ratchet effect” in which
spending in response to a temporary crisis becomes
a permanent increase in spending. Similarly,
additional spending from a one-time revenue
windfall can become a permanent program as staff
are employed and residents receive services, thereby
establishing and entrenching interest groups in
support of program. Recent research into the ratchet
effect published in the widely cited academic journal
       
federal grants to states is associated with a tax
increase of 31–40 cents at the state level and 23–46
cents at the local level, for a total increase of 54–86
cents in new state and local taxes. 4
II. The relationship between federal
intergovernmental transfers and state and
local spending
 
federal grants to states is associated with tax
increases in the range 54 cents to 86 cents in new
state and local taxes.5 Hines & Thaler (1995) and
Bailey & Connolly (1998) provide a review of and
summary of earlier research, including empirical

This study tests the effects of federal
intergovernmental transfers on state and local own-
source general revenue using a balanced panel of
the 50 U.S. states and annual data for 1972 through
2012. Information is not available for the years
1973–1976, 2001, and 2003. Table 1 list the revenue
sources comprising state and local own-source
general revenue for 2012.
Table 1. Components of state and local own-
source general revenue, all states combined
The analysis begins with a graphical analysis of the
relationships between federal transfers to the states
and state and local own-source general revenues.
In this way, one can visualize the extent to which
federal transfers may result in higher state and local
taxes and charges. 6
3 Alexander (2010).
4 Sobel & Crowley (2014); the article provide a review of the research on the “ratchet eect.
5 Sobel & Crowley (2014); the article provide a review of the research on the “ratchet eect.
6 e analysis follows the outline described by Pritchett (2015) and Romer (2015).
Revenue source 2012 Amount Share of Total
Property taxes $445 billion 22%
Sales taxes, general 315 billion 16%
Sales taxes, selective 160 billion 8%
Income tax, individual 305 billion 15%
Income tax, corporate 50 billion 2%
License taxes 70 billion 3%
Other taxes 40 billion 2%
Charges 425 billion 21%
Miscellaneous revenue 200 billion 10%
Total $2,010 billion 100%
8 Impact of Federal Transfers on State and Local Own-Source Spending
     
money going to states and the own-source general
revenues at the state and local level. “Own-source”
means that the money is generated from state and
local taxes and charges. To control for differences in

displayed as a share of total state personal income.
Figure 2. State and local own-source general revenue,
all states combined, 1972–2012
Figure 2 shows that state and local own-source
general revenue varies from year to year, but
shows an upward trend over time. In the 1980s,
spending from state and local sources represented
13.9 percent of personal income, or $468 billion
a year. In the 2000s, the amount grew to $1,217
billion, or 15.1 percent of personal income. In
other words, not only has state and local own-
source revenues grown, but they have grown as
a share of personal income.
Impact of Federal Transfers on State and Local Own-Source Spending 9
8 Impact of Federal Transfers on State and Local Own-Source Spending
Figure 3 shows that state and local revenue from
federal intergovernmental transfers varies from
year to year, but—as with own state and local own-
source general revenue—shows an upward trend
over time. In the 1980s, state and local revenues
from federal transfers represented 2.9 percent of
personal income, or $96 billion a year. In the 2000s,
the amount grew to $372 billion, or 4.2 percent
of personal income. In other words, not only have
federal transfers to states grown, but they have
grown as a share of personal income.
Figure 3. Federal intergovernmental revenue, all states combined, 1972–2012
10 Impact of Federal Transfers on State and Local Own-Source Spending
Figure 4 combines the trends shown in Figure
2 and Figure 3 into a scatterplot showing the
relationship between federal revenue and
spending from state and local sources for all 50
states combined. Each dot represents a single
year. The figure shows an obvious positive
relationship: As federal revenues grow relative
to income, so do state and local revenues. The
trendline indicates that, on average across
the U.S. as a whole, for every percentage point
increase in federal money to states, revenues
from taxes and charges at the state and local
level increase by roughly 0.75 percentage points.
The figure shows the strong correlation of
spending from federal and state/local sources,
but it does not split it into cross-sectional
(states) and time-series components (years) that
research encourages to consider separately. 7
7 Romer (2015).
Figure 4. Relationship between federal intergovernmental revenue and state/local
own-source general revenue, all states combined, 1972–2012
Impact of Federal Transfers on State and Local Own-Source Spending 11
10 Impact of Federal Transfers on State and Local Own-Source Spending
Figure 5 is similar to Figure 4, but displays a
separate dot for each year for each of the 50 states,
for a total of 1,750 dots. The scatterplot has some
outliers at the upper end of state and local own-
source general revenue. Each of these outliers
are associated with the State of Alaska and
are shown as red dots. These outliers distort
the averages and trends in the rest of the data,
which is especially distortionary considering
Alaska represents less than one percent of U.S.
population, output, and incomes.
Figure 5. Relationship between federal intergovernmental revenue and state/local
own-source general revenue, each state (Alaska in red), 1972–2012
12 Impact of Federal Transfers on State and Local Own-Source Spending
Figure 6 is the same as Figure 5, but excludes the
       
data from Alaska.

relationship: As federal revenues grow relative to
income, so do state and local revenues from taxes
and other charges. The trendline indicates that for
every percentage point increase in federal money to
states, taxes and charges at the state and local level
increase by roughly 0.88 percentage points.

from federal and state/local sources, but still does
not split it into cross-sectional (states) and time-
series components (years) suggested by research.
Figure 6. Relationship between federal intergovernmental revenue and state/local
own-source general revenue, each state (Alaska excluded), 1972–2012
Impact of Federal Transfers on State and Local Own-Source Spending 13
12 Impact of Federal Transfers on State and Local Own-Source Spending
Figure 7 shows one simple way to get at the cross-
sectional—state-by-state—variation. It plots
federal revenue and spending from state and local
sources for each state in a single year, 2012. The
      
from federal and state/local sources: States
receiving more federal intergovernmental transfers
also have greater spending from their own state
and local sources. The trendline indicates that for
every percentage point increase in federal money to
states, state and local taxes and charges increase by
roughly 0.74 percentage points.
Figure 7. Relationship between federal intergovernmental revenue and state/local
own-source general revenue, each state, 2012
14 Impact of Federal Transfers on State and Local Own-Source Spending
Figure 8 shows one simple way to get at the variation
over time. It plots the change in federal revenue and
the change in spending from state and local sources
for each state over the years 1972 and 2012.
       
change in spending from federal and the change in
spending state/local sources: States with increasing
intergovernmental transfers also increase collections
from there own-sources such as taxes, fees, and charges.
III. Regression analysis of relationship
between federal intergovernmental
transfers and state and local spending
Another way to deal with the variation over time uses
a statistical approach. One way to separate out the
effect of the changes over time from the persistent
differences in spending among states is to run a

using dummy variable for each state.
Figure 9 shows the correlation between the state
and local own-source general revenue in a given
year and federal intergovernmental transfers in that

dummy and a time trend (red dots). The blue dots
show the initial scatter in Figure 6.
       
effects has a slope that is less steep than the scatter
of points in Figure 6. The trendline indicates that for
every percentage point increase in federal money
to states, state and local spending increases by
roughly 0.74 percentage points. The slope is less
steep because the regression allocates some of this
      
over time. Nevertheless, when examined this way,
the data still show a correlation of spending from
federal and state/local sources.

that each state is different from other states, but
Figure 8. Relationship between percentage point change in federal intergovernmental
revenue and percentage point change in state/local own-source general revenue, each
state, from 1972 to 2012
Impact of Federal Transfers on State and Local Own-Source Spending 15
14 Impact of Federal Transfers on State and Local Own-Source Spending
does not describe the ways in which states differ. It
also does not describe how such differences could
account for spending from state and local taxes,
fees, charges, and other revenue sources apart
from own-source spending associated with federal
intergovernmental transfers.
     
could explain differences in state and local own-
source spending. These controls are typical of
       
governments. Each of the following factors vary
across states and vary from year-to-year:
• Unemployment, share of labor force;8
• Poverty, share of population; 9
• Age 5 and younger, share of population; 10
• Age 5-18, share of population;
• Age 65 and older, share of population;
Mining share of gross state product, is included
to account for state-by-state differences in the
energy and mining sector and also to account for
the recent boom in energy and mining markets; 11
Manufacturing share of gross state product; 12
and
• Population density. 13
Figure 9. Relationship between federal intergovernmental revenue and state/local
own-source general revenue, each state, controlling for state xed effects, 1972–2012
8 See, for example, Gamkhar & Oates (1996); Wrightson et al. (1996); Baicker (2001); Kula (2004); and Brooks and Phillips (2010).
9 See, for example, Wrightson et al. (1996); Gordon (2004); Kula (2004); Payne (2009); and Brooks and Phillips (2010).
10 See, for example, Wrightson et al. (1996) and Brooks and Phillips (2010).
11 Adkisson and Mohammed (2014).
12 See, for example, Clark and Whitford (2011).
13 See, for example, Wrightson et al. (1996); Kula (2004); and Baicker (2005).
16 Impact of Federal Transfers on State and Local Own-Source Spending
Figure 10 shows the correlation between the state
and local own source general revenue in a given
year and federal intergovernmental transfers in
that year after taking out the effect of the state-
      
        
less steep than the scatter of points in Figure 6 and
Figure 9. Nevertheless, when examined this way,
the data still show a correlation of spending from
federal and state/local sources.
Figure 10. Relationship between federal intergovernmental revenue and state/local
own-source general revenue, each state, controlling for economic and demographic
variation, 1972–2012
Impact of Federal Transfers on State and Local Own-Source Spending 17
16 Impact of Federal Transfers on State and Local Own-Source Spending
Table 2. Regression results of relationship
between state/local own-source general
revenue (dependent variable) and federal
intergovernmental revenue, by state,
controlling for economic and demographic
variation, 1980–2012
Table 2 presents the results of a regression that

source general revenue (as a share of state personal
income) and federal intergovernmental revenue (as
a share of state personal income) and controlling
for the economic and demographic factors that vary
across states and over time.
The trendline indicates that for every percentage
point increase in federal money to states, state and
local spending increases by 0.82 percentage points,
which is in line with the estimates provided by
the scatterplot analysis provided in Figures 4–10.
     
         
     
that each dollar of additional federal grants to states
is associated with tax increases in the range 54 cents
to 86 cents in new state and local taxes.14
The regression model has an R-squared statistics of
0.493, which is within the range presented in peer-
reviewed articles in this area of research.
IV. Conclusion
A vast previous literature has examined the impact
of federal grants on state and local spending. Much of
this previous literature, however, focuses exclusively
on the impact of the grant spending rather than on
the state and local own-source revenues. This study
depart from this literature by examining the impact
of federal transfers on state and local taxes and
charges. This is the most comprehensive analysis to
date, using information from U.S. states spanning the
period from 1972 to 2012.
Our results clearly demonstrate that federal transfers
to state and local governments results in higher own-
source revenue and taxes. Importantly, our results
suggest that the increases in federal grants to state
and local governments associated with the ACA’s
  
implications at the state and local level as these
governments raise revenue to continue these newly
funded programs into the future and as federal
support tapers off once the expansion is in place.
Federal transfers to states have grown from $74 billion a year
in 1980 to almost $300 billion in 2012. Based on our results
state revenues from taxes, charges, and other own-sources
will rise by 82 cents for each additional dollar in federal
14 Sobel & Crowley (2014).
Variable Coefficient Std. Error
Constant 0.109 0.008
Federal intergovernmental
revenue 0.817 0.044
Unemployment, share of
labor force –0.018 0.022
Poverty, share of
population –0.086 0.013
Age 5 and younger, share
of population 0.516 0.094
Age 5-18, share of
population –0.123 0.038
Age 65 and older, share of
population 0.040 0.025
Mining share of gross state
product 0.121 0.015
Manufacturing share of
gross state product –0.024 0.006
Population density 2.51E-06 0.000
R-squared 0.493
Adj. R-squared 0.490
Number of observations 1,519
18 Impact of Federal Transfers on State and Local Own-Source Spending
transfers. A hypothetical 10 percent increase in federal
transfers would amount to about $62 billion to the states.
Using our regression results, and holding personal income
constant, this would be associated with approximately
$50 billion in additional increased taxes, charges or other
revenue sources, or an additional government burden of
$158 per person.
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