Synonyms

Intergovernmental fiscal relations; Multilevel government finance

Definition

Fiscal federalism concerns the hierarchical decentralization of governmental fiscal functions, authority, and relations between a national government and subordinate governments (Ostrom et al. 1961; Riker 1964). It is the financial interaction between the different levels of government in a federal system that is characterized by multilevel governments, which addresses the need for equitable distribution of income, maintenance of high employment with stable prices, and establishment of an efficient pattern of resource allocation. Fiscal federalism also deals with understanding the functions and instruments that are best centralized and those that are best decentralized by assigning different roles to different levels of government and providing the needed instruments to perform these functions. In the USA, the levels of government in the federal arrangement are the federal, state, and local governments.

Introduction

Fiscal federalism – a term attributed to Richard Musgrave – is a subfield of public finance that functions as an institutionalized bureaucracy characterized by centralized planning, efficient assignment of functions, and intimate cooperation between the different levels of government. The concept is deeply embedded in the fabrics of American society to optimally deal with certain problems or service activities at the national or subnational level. The relationship shared by the federal, state, and local governments not only is a political or a defense pact but extends to an economic and fiscal relationship that distributes resources equitably among the sovereign states recognizing that some members of the union are more endowed than others. Fiscal federalism assigns the central government the responsibility for macroeconomic stabilization and income redistribution, whereas the decentralized governments provide goods and services whose consumption is limited to their jurisdiction (Oates 1999).

The US federal arrangement started with 13 independent states in 1789, which continued to expand with the admission of new states into the union. Alaska and Hawaii became the 49th and 50th states, respectively, to join the federal republic of the USA in 1959. Over more than two centuries of its existence, American federalism has become, perhaps, the most important political force the world has seen. With its military and political might that is fueled by the fiscal cooperation of the sovereigns in the union, the USA is able to address many of the challenges it faces both domestically and internationally making it a global superpower. The fiscal relationship among the sovereign governments in the federation keeps changing, and these paradigm shifts bring new challenges to the fore.

The present entry examines American federalism with a focus on the fiscal relationship existing between sovereign governments. It discusses the evolution of federalism and the fiscal instruments used when the paradigm shifts. The chapter also discusses benefits and challenges of fiscal federalism as well as how it has been studied by scholars. The chapter concludes with a discussion of the future of fiscal federalism in the USA.

The US Federal Structure

The federal structure of the USA is made up of the federal government and the 50 sovereign states. Although territories such as Porto Rico, Guam, and the American Virgin Islands are part of the USA, these are considered territories and come under American protectorate. The constitution of the USA stipulates powers that are granted to the federal government and indicates that all other powers are reserved to the states including authority over local governments within their boundaries. The formal powers, roles, fiscal instruments used by multilevel governments, and relationships underlying American federalism have evolved over the years and include:

  • State-Centered Federalism

    In the early part of the union under the Articles of Confederation, state-centered federalism (1787–1865) saw the states wielding more influence and power over national policies. Proponents of state-centered federalism including Thomas Jefferson and members of the Republican Party advocated for independent state governance and sovereignty in structuring the political life of residents residing within their jurisdictions. State-centered federalism articulated state rights and left the central government incapacitated with limited enumerated and fiscal powers to raise taxes to fund government operations.

  • Dual Federalism

    After the American Civil War in 1865, the country was ushered into a new era in American politics. Dual federalism (1865–1913) created a distinct and separate sphere of political influence for federal and state governments. Both the federal and state governments maintained exclusive authority over distinct delineated spheres of influence. The central government refrained from interfering in the domestic affairs of states. Political science scholars compared this era to a cake with clearly defined layers representing the different levels of governments, its ascribed powers and responsibilities, hence the term layer cake federalism. For instance, the state governments maintained the responsibility for providing public safety, education, and social welfare needs, whereas the national government provided national security and regulated interstate commerce. Federal revenue sources for public policies ascribed by dual federalism were mainly from custom duties and excise taxes that it levies on citizens, while the states derive revenues from property tax on wealth.

    The major problem inherent in dual federalism is the constant overlap in federal and state jurisdictional responsibilities because the constitution does not explicitly define such power boundaries. Although the Tenth Amendment delegates all powers not expressly stated in the constitution to states, Article 1, Section 8, gives the US Congress the powers to make legislation that are necessary for proper functioning of the country. The Supreme Court has resolved several conflicts emanating from disagreements in the proper authority and jurisdiction of the federal and state governments.

  • Cooperative Federalism

    With the passage of the federal income tax in 1913, the federal government became more dominant because of the wealth from its power to tax all citizens, which led to a radical expansion of Washington’s intergovernmental power. The Great Depression in the 1930s required the federal government to intervene in state and local affairs to address social welfare challenges at the subnational level. Hence, under President Roosevelt’s new deal program, the national government took over the responsibility of protecting the general welfare of citizens through programs such as Social Security Administration. Both the national and state governments jointly funded social welfare and policy programs to tackle the poverty ravaging society. While the federal government derived most of its revenues from income taxes on individuals and corporations, the states and local governments derived their revenues from sales and property tax, respectively.

  • Centralized Federalism

    The 1960s introduced the era of centralized federalism (1964–1980) also known as creative federalism, which essentially gave the federal government the preeminence in making policies, and the states implemented these actions utilizing grants-in-aid or intergovernmental transfers. This form of federalism was coined by President LB Johnson and attempts for all levels of government to jointly partake in the management of intergovernmental programs. To receive funding for policy programs from the central government, states are forced to adopt federally determined objectives. From 1964 upward, social security provided important revenue for the federal government for the implementation of social and welfare programs.

  • New Federalism

    New federalism (1980–1985) emerged in the late twentieth century. President Nixon and Ronald Reagan are credited for popularizing the term “new federalism” as an effort to return autonomy and preeminence in policy areas to the states while maintaining significant level of federal funding. The president imposed new policy objectives on intergovernmental arrangements. Initially, states could only use intergovernmental funds for specific federally approved objectives. However, President Reagan introduced the “block grant” program, which allowed states and local governments greater discretion in the use of federal funds. New federalism presumes that decentralizing fiscal power to states enhances efficiency in administrative spending and improves policy implementation outcomes.

  • Coercive Federalism

    Coercive federalism (1985–1995) focuses on federal-state relationships in policymaking. The powers of the central government were substantially enhanced to override state policies and impose federal objectives and mandates. One of the most significant characteristics of coercive federalism is the fiscal constraints and limited discretion the federal government imposes on subnational governments. For decades statutory and federal laws prohibited state taxation on Internet sales. However, in 2018, the US Supreme Court granted states the right to require and collect taxes from online retailers. Furthermore, the Bipartisan Budget Act (BBA) passed in 2018 obliterated spending limitations, thereby increasing the number of congressional earmarks for government programs compared to previous decades.

  • Manna from Heaven Federalism

    The federalism practiced by President Obama especially during the recession years in 2009 to the end of his presidency in 2016 was the “the angel food cake: Manna from heaven federalism,” where the federal government invests heavily in the states and local governments to save them from regulatory and bureaucratic impediments (Henry 2013). The 2007–2009 Great Recession required the Obama administration to introduce a $787 billion stimulus package as countercyclical measure to recover the economy of the USA.

Benefits of Fiscal Federalism

Fiscal federalism presents governments with several benefits, which include the following:

  • Efficiency in resource allocation to various segments of the nation

    Fiscal federalism is efficient and cost-effective in allocating resources and delivering public services across jurisdictions. Governments can tailor goods and services to the preferences of the local populations. More specifically, decentralized provision of public services likely weakens the spillover effects, ensuring that the resources allocated are received by citizens who are in dire need of it. Furthermore, fiscal federalism empowers each level of government with a taxing authority to levy the local population for the purposes of meeting their preferential needs. For example, property tax is levied at the local level because at this level the benefits of such taxes are more tangible and observable by citizens who pay them (Nukpezah 2019).

  • Increased participation in policy and governing processes

    Fiscal federalism impacts both the economic and political domain of a nation. Citizens relish the political benefits of fiscal federalism when the democratic institutions inherent in the nation effectively utilize financial instruments to address core economic and social issues. For example, during traumatic events at subnational level, resources available at the higher-level governments are made available to locals where they can more effectively respond to crises (Nukpezah 2017).

  • Lower cost of government operations

    By identifying those activities that need to be centralized in national governments and those that should be decentralized at the various levels of subnational governments, control of fiscal responsibilities and decision-making that help governments to minimize the cost of operation is realized. Recurring costs within jurisdictions which have been previously identified to meet the needs of the local population can be internalized. The internalization of the costs relating to public service distribution within jurisdictions also assists in increasing accountability and provides a framework for continuous adjustments to devise more avenues to meet public needs efficiently.

  • Local and regional economic differences are accounted for by intergovernmental transfers

    Fiscal federalism pools public resources together and disseminates it in the form of intergovernmental transfers and grants to subnational governments. The economic stability and efficiency in federal resource allocation to states and local government is attributed to fiscal federalism (Musgrave et al. 1989). Federal grants to state and local governments totaled $474 billion in 2017 alone. During the same period, states transferred about $500 billion to fund local government activities. State funding is a combination of federal grants and revenues raised by the states through taxation and fees.

  • Competition among localities encourages innovations both politically and economically

    Fiscal federalism affords localities with the opportunity to diversify local outputs. Structural variations and funding innovations of key grant outlays such as education, health, housing, and infrastructure make some jurisdictions more competitive than others. The Tiebout model shows that citizens will “vote with their feet” and make choices based on their satisfaction with the taxing requirement and efficiency of service delivery of jurisdictions. The ensuing competition leads to better tax-service packages.

Demerits and Challenges of Fiscal Federalism

There are several impediments faced by democratic countries in the implementation of decentralization. For the USA, possible challenges envisaged include:

  • Lack of Fiscal Autonomy

    Overreliance on federal grants limits the independence of many subnational governments from the control of a predatory central government (Weingast 2014). Although predatory behavior is commonly evident in developing countries where the national government undermines the performance of jurisdictions by inadequately funding their mandates, variants are possible in the USA. In the USA, the federal government has more fiscal resources than subnational governments, which perpetuates continuous dependence. Fiscal autonomy in terms of raising own revenues to sufficiently cater to state welfare needs is critical because it extricates local governments from the manipulative helms of the central governments. Granting lower governments the independence to tax their jurisdiction and diminish the use of transfer funds eliminates manipulation and control of lower-level governments.

  • Insecure Governments

    Democracy imbues citizens with the right to enjoy the provision of certain public goods by virtue of their citizenship; however, insecure governments can perniciously use elections to socially control citizen behaviors and voting preferences rather than promote public welfare. Evidence suggests that districts who opposed the central government faced the dilemma of grant withdrawals (Rodriguz 1995). The national government can design policies that discriminate against certain segment of the population. The larger the discretionary resources available to the central government, the more power it possesses to socially manipulate the behaviors of citizens.

  • Fiscal Imbalances

    An endogenous problem inherent in fiscal federalism is the disparity in power to raise revenues for public expenditures. Literature highlights two forms of tax imbalance: vertical and horizontal imbalances (Oates 1999; Weingast 2009). Vertical imbalance occurs due to disparities in the taxing structure of national and regional governments. The central government maintains a well-structured system of taxation that is uniform and comparatively cheap to administer. The superior tax structure imbues the central government with the ability to raise more taxes for intergovernmental transfers. On the other hand, horizontal fiscal imbalances arise when differences in regional economies directly affect the tax income generated (Weingast 2009). Technically, horizontal inequalities affect the fiscal ability of the locality to provide public services to citizens. Therefore, equalization payments from the national government are required for distribution to struggling localities. More emphasis is placed on vertical imbalances due to inadequacies inherent in the taxing systems of lower-level governments especially in developing countries. Subnational governments continue to encounter challenges in the effective use of their tax base to raise revenues that equal their debt obligations (Oates 2006).

  • Accountability Issues

    Overreliance on federal grants has the tendency of making regional governments less accountable to voters and uncreative in public sector operations (Bahl and Linn 1992). Public officials contribute to the dilemma by serving to implement their own interests, which expands the budget (Musgrave et al. 1989). The federal funds are used in maximizing the size of the bureau or increase salaries rather than cater to the needs of citizens. However, in recent years, the financial role played by the central government in financing the activities of state and local governments continues to diminish, thereby assigning those responsibilities to lower governments. Federal aid to states has, however, been dwindling since the 1980s. Devolution of fiscal responsibilities to lower levels of government for the provision of public goods and services has increasingly caused regional governments to experience revenue shortfalls and thereby exercise discretion in maintaining balanced budgets and curtailing expenditures (Bae et al. 2012).

Federalism and Revenue Sources

The federal government obtains revenues to finance its public policy decisions primarily through income taxes. In 2018, for example, total federal revenue received was more than $3.3 trillion, which is about 16.5% of GDP. Sources of federal revenues include individual income, payroll, corporate, excise, estate, and gift taxes. The total amount of revenues received each year by the federal government increases as the economy flourishes.

Before 1913, the primary source of government revenue for the federal government was tariffs, excise taxes, and fees obtained from the sale of frontier lands. After 1913, however, the federal government raised revenue through the individual and corporate income tax as well as social security and excise taxes. Individual income taxes accounted for the largest (51%) source of federal government revenues in 2018. This encompasses taxes collected from the wages and salaries earned by individuals, income from investments, and other forms of income. Payroll taxes, also known as social insurance taxes, are the second largest component of federal revenues (constituted 35% of federal revenues) and are used to fund Social Security, Medicare, and unemployment insurance. In 2018, most corporate income was taxed at 21% at the federal level and constituted 6% of federal revenues. Excise taxes that are levied on goods such as tobacco, alcohol, and motor fuels contributed about 3% to federal revenues. Estate and gift taxes contributed just a small portion of federal revenues. In 2018, only estates over $11.18 million were subject to federal taxes.

In the early part of US history, property tax is the paramount financial instrument used by the state governments. However, with the adoption of sales tax, the use of property tax was delegated to local governments because it is more efficient to collect at that level due to less bureaucratic bottlenecks (Nukpezah 2019). While property tax contributed less than 2% of state revenues in 2016, it accounted for more than 40% of the $1.4 trillion local government revenues for that year. The main sources of state revenues include sales tax, which contributed 30% of states’ $1.6 trillion dollar revenues. General sales tax is not collected at the federal level although local options are available in some states.

States that contribute the highest revenues to the federal government include California ($227,530,971), New York ($133,256,731), and Texas ($117,748,038). Other major contributors are Florida, Illinois, New Jersey, Pennsylvania, and Massachusetts. On the other hand, states that contribute less to the federal purse include Vermont ($2,507,137), Wyoming ($2,862,573), and Alaska ($3,479,163), partly because of their smaller population. The more populous states tend to contribute more to the federal purse. For example, California alone makes more federal contributions than the 25 lowest-paying states combined. The top ten states contribute almost 60% of all federal tax revenues. While economic activities are more vibrant in the top 20 states, they also enjoy larger populations. States with high income levels usually have higher tax burdens, sometimes above national average. In the USA, an average adult pays $5,512 in federal taxes. However, residents in the ten highest paying states contribute at least $1,282 higher than the national average. The top four states contribute the bulk in federal contributions even though only 11.8% of the US population resides in those states.

The major receivers of federal aids are states with exceptional high rates of poverty, which include Mississippi, Alabama, Louisiana, New Mexico, and Maine. Large disbursements are funneled to these states to finance safety net programs such as Medicare, Medicaid, SNAP, and Social Security. About 40 states receive more federal aids than the contribution they make to the national purse. The ten states that contribute more to the federal purse but receive less funding include Connecticut, Massachusetts, New Jersey, New York, North Dakota, Illinois, New Hampshire, Washington State, Nebraska, and Colorado.

First and Second Generation of Fiscal Federalism

Oates (2005) groups the study of fiscal federalism along the lines of first- and second-generation theories of fiscal federalism and asserts that first-generation theories sought to correct various forms of market failures, promote equitable distribution of incomes, and stabilize the macroeconomy at high levels of unemployment and suggests that each level of government seeks to maximize the social welfare of their respective constituencies.

First-generation theories (FGT) are also concerned with understanding the performance of the federal government at redistributing resources to subnational governments and how public taxation is utilized to promote economic development and stability at the national level. The underlying efforts to design suitable schemes for redistributing income and public services from central to regional governments are to achieve efficiency. More specifically, the focus is to solve the problem of vertical imbalances inherent in intergovernmental transfers and the decentralization of expenditure.

First-generation theories are largely normative and assume that public decision-makers are benevolent maximizers of social welfare (Weingast 2007). The centralization of revenue responsibilities ensures that the consumption of resources is uniformly achieved across jurisdictions. However, decentralizing the provision of public services and goods helps jurisdictions to internalize benefits and weigh the costs of programs (Oates 1972; Tiebout 1956). Local outputs are more efficiently tailored to meet the demands of residents in each jurisdiction compared to centralized activities. Maximizing social welfare at varying degrees across jurisdictions on grounds of efficiency can be performed adequately by the lowest level of government due to its proximity to residents and discernment of cost conditions and preferences.

Second-generation theory (SGT) of fiscal federalism draws from the theories of public choice and political economy to study fiscal federalism. SGT builds on FGT and focuses on equalizing the redistribution of resources across regions while taking into consideration the political interests of public officials to foster the growth of subregional economies. The underlying assumption of SGT is that public officials have goals induced by political institutions that often diverge from maximizing citizen welfare (Weingast 2007). Thus, the SGT takes into consideration both the objectives of public officials and residents in maximizing resources to derive incentives.

Second-generation theories also support market-preserving federalism, a special type of federalism that limits the degree to which a country’s political system can encroach upon its markets. Extant scholarship on market-preserving federalism suggests that the stability of a federal structure hinges on the mutual interaction of political and economic mechanisms (Oates 2006; Weingast 1995). Since political structures and rule of law play a significant role in sustaining or deterring economic growth in a federal system, an assumption of market-preserving federalism is the consent from the national government to refrain from interfering in the delegated authority of lower governments in order to maintain continued support.

Market-preserving federalism is sustained by regulating the economic powers of lower governments in monopolizing the mobility of public resources. The elimination of rent-seeking behaviors and creation of monopolies by lower governments impede corruption. Extensive corruption is prone to occur when governments are granted special privileges to create monopolies or give preferential treatment to certain interest groups particularly in developing nations (Weingast 2009). Curtailing the regulatory and monopolistic powers of lower governments provides an equal opportunity for regional governments to compete in a regulated environment. Public choice phenomena grant consumer taxpayers (based on their ability to pay) the power to choose the best among jurisdictions employing economic variations in the provision of social amenities.

On the fiscal side of market-preserving federalism, discreet macroeconomic policies are utilized by the central government to maintain economic stability and formulate effective techniques for public resource redistribution (Ostrom et al. 1961). Self-enforcing principles such as formal budget constraints are used in regulating the fiscal behaviors and demands of lower-level governments.

Conclusion

Fiscal federalism provides an economic framework that allows federal, state, and local governments to interact in the distribution of resources among various levels of governments for the benefit of their people. Federal aids disbursed to subnational governments continue to increase in scope to fund government programs and agencies. For example, one estimate suggests federal aid spending in 2018 was $697 billion to fund 1,386 agency programs. Compared to when the American federalism started in the 1780s, the amount of aids received by states and local governments in the twenty-first century has grown steadily since President Johnson’s administration making citizens to perceive the strength of the federation. Concerns about the large federal budget and deficit have caused some governments to cut some programs. However, as some programs are cut, new ones are created, which makes it a zero-sum game. The federal budget continues to grow.

All states benefit one way or the other fiscally from the American fiscal federalism. As discussed in this chapter entry, the American federalism has evolved over the last two centuries of its existence. The adoption of various fiscal instruments such as federal income tax, state sales tax, and local property tax has influenced what source of revenue each level utilizes within the federal arrangement. Also, various presidents and their ideologies regarding whether federalism should be state-led or federal government-led has shaped the federal relationship. One thing is certain. The American federalism will continue to evolve, but it will continue to combine the strengths of having a national sovereign and decentralized subnational governments that represent the interests of their citizens and provide benefits to all residents.

Cross-References