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The End of Welfare? Consequences of Federal Devolution for the Nation

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The End of Welfare? (book cover)JANUARY 2000 | EPI Book

The End of Welfare?
Consequences of Federal Devolution for the Nation

Max Sawicky, ed.

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TABLE OF CONTENTS
CHAPTER 1: The New American Devolution: Problems and Prospects, Max B. Sawicky

CHAPTER 2: New Opportunities, Nagging Questions: The Politics of State Policymaking in the 1990s, Timothy J. Conlon & James D. Riggle

CHAPTER 3: The State Fiscal Predicament Under the New Federalism, Steven D. Gold & Bruce A. Wallin

CHAPTER 4: How Strong Are State Revenue Systems? Daphne A. Kenyon

CHAPTER 5: Growing State Economies: How Taxes and Public Services Affect Private-Sector Performance, Timothy J. Bartik

CHAPTER 6: Economic Development and Metropolitan Sprawl: Changing Who Pays and Who Benefits, Joseph J. Persky & Wim Wiewel

CHAPTER 7: State Fiscal Responses to Block Grants: Will the Social Safety Net Survive? Howard Chernick & Andrew Reschovsky

CHAPTER 8: Fiscal Disparities and Education Finance, John M. Yinger

CHAPTER 9: Revenue Sharing as a Public Investment: Why Unrestricted Aid to Governments Will Stimulate Municipal Capital Expenditures, Bruce A. Wallin

APPENDIX: Population, Income, Poverty, and Standardized Fiscal Health
Index

INTRODUCTION

The New American Devolution: Problems and Prospects

by Max Sawicky

Like the weather, for years people talked about federalism without doing anything about it. That all changed with the 104th Congress of 1995-96, which launched a more earnest push than previous advocates of new federalism for devolution of the public sector B shifting tax and spending responsibilities from the Federal government to the states.

Prior to 1995, state and local governments had already grown significantly. Figure 1 depicts the trend in receipts by level of government, as a share of the economy as a whole. It is interesting to note that contrary to concerns about “tax competition” for increasingly footloose taxpayers in a globalizing economy, revenues have seen increases since 1980. As John Shannon has pointed out, there has been no meltdown in state and local governments’ command over taxable resources.

On the expenditure side, in one important sense the states are already more prominent than the Federal government. The vast bulk of Federal expenditures — 68 percent in 1997 B is devoted to Social Security/Medicare, defense spending, and net interest outlays. Correspondingly, much of what we normally associate with the term “government,” in terms of services directly provided to the public at large by government employees, is under the purview of the states.

If we exclude Social Security, Medicare, net interest on the Federal debt, and defense from the total expenditures of Federal, state, and local governments in the U.S., 80% of what remains is administered by state and local governments. In addition, most public investment (infrastructure, education, and training) is financed by state governments, and most infrastructure facilities “reside” in the states.

So it could be said that the vast bulk of national domestic policy is already decentralized or ‘devolved,’ after recognizing the Federal spending on transfer payments and grants-in-aid whose disposition is controlled by the recipient families and sub-Federal governments. Accordingly, one may ask how much more privatization or devolution is conceivable in the most fundamental respects.

The 104th Congress answered in two basic ways. First and foremost, under the rubric of welfare reform it replaced the unpopular Aid to Families with Dependent Children with a new program known as Temporary Assistance for Needy Families (TANF). TANF vests substantially increased discretion in state governments for providing public assistance.

Second, the Congress addressed a long-standing complaint of state and local governments: the promulgation of legislation, regulations, and judicial decisions that are binding on said governments, known generically as ‘mandates.’ Under the Unfunded Mandates Reform Act, legislation that includes new mandates is subject to comprehensive cost impact analysis before proceeding to final consideration by Congress.

A less direct, more long-standing policy with devolutionary implications was the plan to balance the Federal budget forged between the 105th Congress and President Clinton. Included in budget law is a freeze on spending for Federal domestic discretionary programs. The freeze is stipulated in terms of a fixed dollar “cap” which is not adjusted for inflation. The implication is that spending of this type must decrease in real terms and as a share of the economy.

It turns out that almost all grants in aid to state and local governments, with the exception of the Medicaid program, fall into the category of capped expenditures, so budget balancing rules entail an erosion of aid to governments. Unlike Medicaid funds, whose use is specified in Federal law, state and local governments have significant discretion over the use of other grants-in-aid. Any reduction in such funds implies another de facto transfer of policy initiative from the Federal government to the states.

The extent of scheduled cuts in the 1997 budget deal was about $65 billion, after adjusting for inflation. One corollary of these cuts is a projected decline in public investment B spending on infrastructure, education and training, and research and development (GAO, 1997). The 1997 deal was not unique in this regard. Deficit politics and budget rules conspired throughout the 1980s to squeeze domestic discretionary spending, grants-in-aid (Kenyon, 1992), and public investment (Sawicky, 1992). Increases in Medicaid grants could only have been partial recompense, given the restrictions on the use of such funds.
The advances in devolution have been legislated under the umbrella of a relatively long economic recovery marked by record lows in unemployment. All revolutions should enjoy such fair weather. In less happy economic times, the new extent of decentralization in the U.S. public sector could cause some important pressure points to blow their gaskets, so to speak.

The leading concern is the effect of moving large numbers of welfare recipients into labor markets (Bernstein, 1998), since unemployment will probably not remain low indefinitely. There is some doubt that state governments will be able to finance welfare needs under the new system in the teeth of a real economic downturn. There are also questions as to the states’ ability to cope with the social consequences of large numbers of recipients hitting the time limits and being rendered ineligible for assistance. Another source of anxiety is fear that economic changes raise the pitch of competition between state and local governments for tax bases, and conversely encourage an unseemly contest to repel or expel those perceived to bring net financial burdens to the public sector.

A second set of difficulties pertains to prospective changes in health care. To some extent, Federal reforms in the health care field will shift costs to the state-local sector. One possibility is that voters will look to the states for services that the Federal government no longer provides or subsidizes to the same extent. The leading case in point would be a change in the status of nursing home residents now supported by Federal programs. A second is that expansion of Medicaid eligibility brings automatic state matching requirements. A third is that a Federal squeeze
on Medicare providers in the form of reduced payments could drive beneficiaries into the Medicaid program and increase the states’ fiscal burden.

The third area of difficulty is the trend in Federal aid. While cuts in the past have been substantially replaced with state revenues, this may not continue indefinitely. Moreover, the costs of cuts may be less apparent by virtue of the fact that they facilitated deferral or neglect of public investment priorities, particularly in infrastructure and education.

State and local governments have been forced into ever-increasing self-reliance for some time. Since 1981, there has been a dearth of lasting Federal initiatives in domestic policy. Some of the few exceptions have increased the states’ financial responsibilities, including new mandates and expansion of Medicaid eligibility (Kenyon, 1992; Conlan, 1986).

This book offers research that bears on new and incipient pressure points. It evaluates some ways of coping at the state level, and suggests some approaches to recasting Federal policy.

This book’s contributions are of two types. The first speaks to background topics in state fiscal policy. Devolution is an inescapable feature of this setting, but it is not the only one. Trends that predate the current policy regime, such as the erosion of aid to governments, obviously inform present circumstances, including the fate of devolution itself.

The second type delves into three missions that state and local governments pursue by means of expenditure programs. In some cases these missions have been directly expanded by devolutionary measures, the primary example being welfare reform. In others, the halt of Federal initiatives or the erosion of grants-in-aid puts a new premium on self-reliance. In either case, there will be consequences for the nation that spill over state boundaries, beyond the reach of individual state governments. These studies provide some guidance in areas where a resumption of Federal initiative may be appropriate.

In summary, this book offers new insights and findings on the setting in which devolution has begun, the fiscal ramifications of these developments, and a sample of policy recommendations. To be sure, there are many miles yet to be traveled in this journey. Hopefully, this volume will provide the reader with a map of where we’ve been and where, given the natural limitations of foresight, we may be headed.

The Setting for State Policy
The book begins with studies of the economic and political background for public policy in the states. Tim Conlan and James Riggle discuss the changed administrative and political nature of state governments. Steve Gold and Bruce Wallin discuss the fiscal environment. Daphne Kenyon evaluates the strength of state revenue systems. Tim Bartik analyzes the effects of tax competition on state economies. Joseph Persky and Wim Wiewel describe basic tensions arising from the political separation and economic integration of city and suburb that are increasingly a concern of state policy-making.

The Political Environment
Conlan and Riggle open with an optimistic survey of improvements in state government administrative capacity, political responsiveness, and policy initiative over the past fifty years. Their conclusion is that while constraints on policy activism in the states are inescapable, conditions for greater activism have changed decisively for the better.

They begin by reviewing the fundamentally restrictive ‘ground rules’ of our federal system, ordained by our Constitution and our political tradition of classical liberalism. Before the rise of the national government, these rules made for a narrow view of public responsibilities epitomized by such phrases as “the night watchman state.” This ice was broken decisively by the economic crisis of the 1930’s and national security concerns after World War II, leading to a steady growth in the Federal government and the U.S. public sector as a whole. The spectacle of a dynamic, expanding national government reinforced the image of benighted state government.

In contrast to the popular ideology of limited government, Conlan and Riggle cite evidence of widespread “operational liberalism,” which means that in specific practical cases, such as transportation or environmental clean up, there is broad public support for government activism. Perhaps paradoxically, activism by a handful of states in limited areas has given rise to major, national generalizations of such efforts. The best example is state-based social insurance being succeeded by the national Social Security system.

It could be argued that the diversity of states generates isolated, intense commitments of public effort which stand a chance of catching fire at the national level, if only they are first allowed to emerge in relatively pristine form in individual states. The ‘laboratory of federalism’ may also be something of a ‘hot house'; new policies can germinate in environments that are more conducive to innovation than the national government. As Robert Nathan (1990) has suggested, a time of Federal retrenchment can also be a time for state activism.

Against the flexible pragmatism of public opinion regarding proper roles for government, Conlan and Riggle raise a few warning flags. One is planted in economic realities that may constrain state initiatives in certain areas, particularly income redistribution. A second pertains to periodically low public interest in state and local government activities.

The Depression cemented an image of state governments as mean and incompetent. They failed to grant full political rights to minorities, and they were economically and administratively incapable of performing basic tasks. Conlan and Riggle trace the progress of the states from their nadir. One thread is the growth of state government power, in the form of strengthened gubernatorial prerogatives, more rational organization of functions, and some advance in respect of ethical considerations. A second is the expansion of state revenue systems relative to the size of the economy and compared to the Federal government since 1950 (and even since 1980). A third is the spread of the political franchise to excluded minorities, the intensification of inter-party competition, the decline of single interest groups’ domination of specific states, and improved apportionment of legislative representation.

President Clinton has famously remarked that “the era of big government is over,” but it may only be that we are witnessing a passing of the baton of public activism to the states. As noted above, state and local spending has been growing and may advance even more in the wake of such Federal devolution measures as welfare reform.

Conlan and Riggle sketch two contrasting scenarios for the future. Under one, the fever to cut taxes and spending cascades from the national government to the states, driven in significant part by the devolution of public assistance. Welfare reform and tax competition could lead to a “race to the bottom” (Peterson, 199x) in benefit standards and public spending in general. The Republican realignment could become permanent and lead to lasting reductions in the size of government at all levels.

The natural make-up of U.S. federalism, on the other hand, could function as a ‘shock absorber’ and dilute a national, devolutionary impulse. Federalism disperses power and slows the march of all manner of ideological crusades. In policy as in war, it may be easier to play defense than offense. The legacy of the New Deal and Great Society may prove capable of withstanding threats from devolution. Newly enfranchised groups will not easily surrender their basic rights, and new interest groups will not neglect their well being.

On the whole, Conlan and Riggle show that policy-making in the states will not be easy to predict. Evidence for a new activism is no less forthcoming than the prospects for a contraction of the U.S. public sector at all levels.

The Fiscal Outlook
Before his untimely death, Steve Gold submitted a first draft to the project from which this collection originated. Bruce Wallin has revised and updated Gold’s draft for presentation here.

Gold and Wallin foresee profound implications for the states arising from the decisions pending in the 104th Congress. Along with external factors, these decisions point to projected “structural deficits” in the states’ futures, which means that under the maintenance of current policies, state government budgets will run short of tax revenue and be obliged to either reduce spending or to increase taxes.

The most familiar factor in national policy has been the slow-motion decline in Federal aid to state and local governments since 1978 (excluding Medicaid), given the imperatives to balance the Federal budget and to implement cost-cutting measures in the Medicaid program noted at the outset of this essay.

Alongside the projected, further declines in Federal aid is the welfare reform measure passed in 1996. Changing AFDC to a block grant means that aid will not be as responsive to changing economic conditions. A ‘rainy-day’ fund was provided for by the reform, but as Chernick and Reschovsky show in their contribution to this volume, the fund is highly unlikely to be adequate in a recession.

Gold and Wallin explore the role of external factors that are independent of national policy. One is the projected decline in economic growth. Another set consists of demographic trends that are expected to increase the need for public school expenditures, higher education, and Medicaid. A third is the rapid rise in correction costs, in the wake of new state policies on sentencing convicted criminals.

Gold and Wallin find public opinion much the same as Conlan and Riggle. “Operational liberalism” is borne out in a lack of demand for major spending reductions. As noted above and shown in Figure 1, total state-local spending has not declined since 1980. To some extent, such spending is propped up by Federal mandates (Kenyon, 1992).

In the face of incipient spending pressures, the authors suspect existing revenue systems to be inadequate. This topic is taken up in greater detail in Kenyon’s contribution, discussed below. State income tax revenues keep up with economic growth, by and large, but these contribute only 30 to 40 percent of state revenue. Moreover, recent changes in some states have rendered income taxes less ‘elastic’ with respect to the economy, which means revenues fail to keep pace with economic growth. Other state revenue sources are ‘inelastic’ for other reasons.

Gold and Wallin note that in boom times, budget surpluses are generated and politically popular tax cuts are possible. The real test of state revenue systems is only imposed over the course of an entire business cycle. It is too soon to predict whether states will try to recoup revenues in the next recession or choose to cut services instead.

Against this background, the authors address the principal questions surrounding devolution. The largest one — health care — is also one of the least clear, given the uncertainty about the rate of growth of costs and effects of Federal Medicare reform and industry restructuring on the states.

More obvious is the direction of public assistance, in the new form of the TANF program. Spending is clearly expected to decrease; the questions are by how much, and with what consequences. The present period of low caseloads is anomalous. Recession and the onset of time limits could force another reorganization of the program. Federal spending cuts will put downward pressure on public investment and social services in general.

In coping with future structural deficits, Gold and Wallin recommend that state governments consider ways of reducing pressure on local governments, in the form of fewer mandates, more technical assistance, and better targeting of aid. The authors are sympathetic to the agenda of “reinventing government,” but warn that the measures under this rubric “confront major problems and can be misused.”

In regard to revenue systems, Gold and Wallin worry about increasing pressure on the property tax in light of its burden on the poor and elderly. More generally, they want states to focus on income taxation, in order to avoid making their systems more regressive, and to make revenues more elastic.

The Strength of Revenue Systems
Daphne Kenyon takes up the problems faced by state revenue systems in depth. She begins by citing four major challenges faced by state governments: cuts in Federal aid, significant reform of Federal taxes, increasing demands for state and local public services, and expectations of recession at some point in the near future. She concludes by sketching three alternative scenarios: fiscal crisis, muddling through, or structural reform.

The most basic problem for state government finance is the lag between revenue growth and the demand for spending. Perennial mismatches entail continuous deficits and the need for constant revision of state tax codes and redesign of public spending programs. Some would contend that governments should be obliged to take explicit measures to increase revenues for the sake of political accountability.

A counter-argument is that this places an arbitrary burden on government in the exercise of one particular function, namely countenancing the maintenance of an expanding public sector. One could argue with equal logic that government should be obliged to go to voters for permission to contract or maintain the status quo as well. The upshot of the latter argument is that government ought to be in a state of constant, comprehensive evaluation of its entire span of functions, reinventing everything in each budget cycle. One could argue instead that major functions should be reviewed individually, with the benefit of heightened scrutiny made possible by a focus of the political system’s time and resources.

A second key problem for states is the cyclical pattern of revenues and outlays. During recessions, revenues lag more than usual and spending demands are heightened. State deficits thus loom largest when the economy is slow and neither tax increases nor spending cuts are particularly desirable from the standpoint of fiscal policy.

Kenyon classifies states’ remedies to the previous recession in the ‘muddling through’ category. One source of extra resources was a loophole (since closed) in the Medicaid program that enabled states to increase Federal contributions. A second was shifting costs to local governments through cuts or slowdowns in state aid. A third was reduced support for higher education. A fourth was a resort to the primordial grab bag of one-shot fiscal hole plugging, often in the form of creative accounting devices.

Kenyon sees expansion of broad-based taxes on income or retail sales as a fundamental reform and notes it has been used sparingly. When the next recession hits, she expects revenue shortfalls in the neighborhood of ten to twenty percent of state revenue. In light of historical experience, she doubts that tax increases could be agreed upon to fill more than half the gap.

Two factors that bear on this finding are possible cuts in Federal spending and taxes, the first of which could increase demands at the state level, and the second of which affords the states some room for tax increases.

Every state has a unique revenue system, so problems and solutions will naturally play out in different forms in different places (Wallin, 1996). Kenyon depicts the ideal situation as a revenue system with a broad-based tax that is under-utilized. Great political difficulties ensue from either trying to enact such a tax de novo, or from milking such a revenue source when it is already being exploited.

Putting business cycles aside, states face some long-term trends that are adverse to revenue growth. One is the decreasing elasticity of their revenues, due to the increasing use o
f such measures as indexing of income tax brackets for inflation, flattening of rate structures (mainly via elimination of top rates), and implementation of new tax limitation measures. A second is the possibility of increasing tax competition, partly due to ‘globalization’ of the economy. A third is the shift in the nation’s output and consumption from manufactured goods to services and to electronic commerce, the latter of which are favored or ignored altogether under existing retail sales taxes.

What is the outlook in light of these problems? Kenyon sees three main possibilities. One is of of much deeper state fiscal crises than experienced in recent decades. A second follows if Federal aid gets a new lease on life and economic growth continues to exceed expectations. States may be able to muddle through. A third scenario is that crisis might be heroically met with comprehensive reform in the states. Kenyon’s favored solution is some mode of tax coordination among the states that precludes problems of tax competition and exploits the broad-based revenue source most utilized by state and local governments: consumption.

Economic Growth and State Government Budgets
As state fiscal policy is driven by economic factors, so too it has some effect on these factors as well. The nature of such ‘feedback’ is a long-standing debate in the realms of both tax and expenditure policy. Tim Bartik offers an empirical analysis of the effects of state fiscal policy on employment.

Underlying the debate over the effects of state budgets are two competing ‘supply-side’ doctrines. One holds that tax reductions promise significant benefits for economic growth, employment, and incomes. Another finds public spending, especially for investment in such things as infrastructure and education, to have that very same salutary benefit.

In both cases it is necessary to distinguish between economic ‘dividends’ in the form of private sector employment and income growth, on the one hand, and the benefits (or lack thereof) of public services. A larger public sector could benefit or harm households but not affect jobs or income, simply by providing services whose costs exceed their benefits. A smaller government could do likewise by withholding services whose benefits exceed their costs. Bartik’s objective is to isolate the ‘dividends,’ if any, after abstracting from the size of government.

In isolation, it is natural to expect taxes to have a negative impact on jobs and income, and public spending to have a positive effect. The real issue is how a ‘balanced budget’ change in taxes and spending plays out. Bartik finds the effects of taxes and spending within states to be mutually offsetting. Larger or smaller public sectors do not bring positive or negative dividends, given the current range of likely possibilities. This means the proper focus for state policy-makers is simply the benefits of public services to households. There is little prospect of a supply-side boost in either direction from an expansion or contraction of government.

A second finding in Bartik, which he takes to be surprising and therefore inconclusive, is that state spending for most public purposes has significant ‘spill-over’ effects. This means that when a given state undertakes public service provision, its neighbors derive benefits. From the national standpoint, therefore states acting in isolation from each other will tend to spend too little. Some kind of coordination for increased spending would bring general benefit. There would be no parallel disadvantage to the higher taxes necessary to finance such an expansion because there would be no competitive effect under a coordinated tax increase in all states. The other sort of coordination mechanism, of course, would be a reversal in the trend of declining Federal aid.

Cities, Suburbs, and the Public Interest
Because distances are shorter and barriers to mobility lower, state governments more than national ones need to consider how their policies affect the migration of households and the location decisions of business firms. The most fundamental spatial factor in the states is the division of city and suburb within metropolitan areas. The basic building block of our national economy is the metropolitan region, shaped by the dynamics of urbanization and suburbanization.

Joseph Persky and Wim Wiewel explore the economics of space in metropolitan regions, pointing out that this most obvious of economic entities is paid little heed in politics or policy discussions. The primary issue is the coordination problem in the assignment of space and location to economic tasks. Some patterns of location will clearly be more efficient than others, but individual, market-based choices will not necessarily give rise to efficient results. What is inefficient for the region could easily appear to be rational and advantageous to an individual decision-maker.

A simple example is commuting by car. An individual may prefer to travel to work by personal automobile. If many others feel the same way, congestion and pollution costs could be significant. For an individual, it can make sense to drive because she does not bear any of the cost she imposes on all other drivers as a group. Stepping back, fewer drivers might result in an increase in aggregate well being, but no individual driver can make herself better off by abstaining from driving.

The problems of unplanned, unregulated suburbanization include those of congestion and pollution noted above, as well as the over-use of open space outside cities, labor shortages in the suburbs, labor surpluses within cities, insufficient use of urban infrastructure, and excessive cost of redundant, suburban infrastructure.

In the context of reductions in Federal aid and potentially destabilizing welfare reform, the diseconomies of excessive suburbanization loom larger. From a political standpoint, devolution diminishes the prospects of the national government acting as a mediating body between city and suburb. Worsening social conditions in cities can exacerbate suburban sprawl and deepen urban unemployment. Moreover, rings of ‘inner suburbs’ have developed around central cities, and these areas have been vulnerable to the same problems as the city proper.

The basic pattern may be summarized as an increase in development, taxable property, and employed residents in suburbs, against a decay of cities and a diminishing population of urban resident earners. This can have dire fiscal implications. Downtown central business districts are lucrative sources of tax revenue, but such revenues may not be equal to the cities’ needs, and the proximity of suburban locations gives business firms a credible threat to ward off taxation. While suburbanites continue to work in cities, their susceptibility to taxation in urban jurisdictions can be limited by restrictions originating in state capitals. In the U.S. federal system, all local governments are creatures of sovereign state governments. The economics of suburbanization are mirrored by shifts in political power from city to suburb.

The upshot is a double-barreled fiscal disparity between city and suburb: accessible tax bases tend to be concentrated outside of cities, and public needs tend to be bunched inside them. This lends additional impetus to existing, inefficient incentives for suburbanization and bolsters diagnoses of the economic dysfunctionality of cities.

Contradicting this scenario is the simple fact that city economies are refusing to die and are even showing signs of a renaissance. The vaunted service economy, replete with communications gadgets of every description, seems to find urban locations congenial for many important purposes. For instance, what are called producer- or high-end services (finance, legal, insurance, advertising, accountancy, and printing) find the availability of face-to-face communication useful, the ubiquity of faxes, e-mail, and video conferencing notwithstanding. Some service provision has economies
of scale in terms of the facility from which service workers operate. Many younger, highly skilled employees of service firms, as well as some retired persons, have an interest in urban life and the unique types of recreational pursuits it offers.

Alongside the vibrancy of CBD’s is the decay of neighborhoods of low-income families. Amongst this inventory of idle hands and neglected potential are infrastructure facilities that have been left to deteriorate, even as the nation’s unemployment rate enjoys record lows. While pockets of high unemployment have shown some improvement in the current economy, much distress remains to be alleviated and will probably require targeted policies.

A standard concept in economics is the trade-off between equity and efficiency, but the alleviation of fiscal disparities and urban/suburban economic inequality is a major exception. As noted above, low-income urban residents and space are both underutilized, in part because of public policies with economically perverse incentives. What is efficient can also be equitable in this context.
Persky and Wiewel emphasize the need to go beyond generalities that either support or refute these assertions. In particular, the costs and benefits of well-specified public projects ought to be studied. This would also enrich the political debate, which seems to have run aground on the thesis that public investment can be desirable, but it is not clear exactly what sort of investment deserves the highest priority. The political system seems to default to support of sport stadiums and similar projects whose analytical merits are clearly overshadowed by more mundane political interests.

In the latter vein, Persky and Wiewel estimate the costs and benefits associated with the location of households with varying incomes in cities and suburbs. They find that all but high-income households (the latter defined as greater than $75,000 annual income) generate net fiscal costs by locating in suburbs, which means less taxes are paid than public sector benefits received. Only the highest income families “pay their way” (and then some). By contrast, in cities only low-income households (defined as $30,000 or less) generate such costs, which from an equity standpoint is not an undesirable outcome.
Persky and Wiewel’s estimates of the social costs of household location decisions, such as congestion, loss of green space, etc., underscore the likelihood of economic inefficiency in suburbanization.

Another dimension is the effect on employment and business firm location. While firms provide jobs, they also generate congestion, pollution, and other external costs. Transportation systems are dominated by the spokes on a wheel. They typically focus on getting workers into city job locations, not on the reverse, nor on moving suburban workers from one suburban location to another. Location decisions can also create mismatches between job opportunities and labor supply, since firms, like the commuters in our previous example, only take their individual well being into account.

All of these wide-ranging considerations inform the economic framework for analyzing the efficiency of suburbanization. The purpose is to delineate a desirable field of intensive research, not to utter last words on the topic. Persky and Wiewel also want to encourage policy-makers to consider the deeper economic ramifications of policy decisions that affect location in metropolitan areas, and to analyze and motivate policies that would reverse the existing bias towards inefficient suburbanization.

Policy responses include reducing the tax advantages afforded to owner-occupied housing, upgrading public transportation systems to facilitate intra-urban commuting and ‘reverse commuting,’ targeting tax and expenditure subsidies to inner-city areas, supporting affordable housing in suburbs, implementing growth management controls, setting impact fees for housing construction, sharing tax bases, and strengthening regional government in general.

Block Grants as Welfare Reform
As noted at the outset of this introduction, the most decisive act of devolution was the Personal Responsibility and Work Opportunity Act of 1996. PRWOA eliminated the Federal entitlement to cash assistance and changed the Federal financing of cash assistance from matching grants to block grants. It also imposed lifetime limits on eligibility for assistance. The Republican leadership in Congress favored similar treatment for the Medicaid program but failed to pass such a measure over the objections of the Clinton Administration.
Andrew Reschovsky and Howard Chernick consider the implications of turning these programs into block grants. They estimate that cash benefit levels would fall by 17 to 25 percent if both AFDC and Medicaid were converted into block grants, and total spending would fall by about 30 percent, due to reduction in caseloads occasioned by the benefit cuts.

The old AFDC program was designed by the national government, jointly financed by Federal and state governments, and administered by the states. The financing was effected through matching grants, which means that a given dollar of spending costs state governments and their taxpayers less than a dollar. For instance, with a 78 percent match, Mississippi could increase its welfare spending by a dollar and be reimbursed with 78 cents, which means it would end up spending only 22 cents of its own money. Economists have provided substantial statistical evidence that matching aid encourages higher spending by states. By the same token, elimination of such provisions increases the “tax price” of welfare and should decrease state spending.

Reduced state spending must be absorbed by a reduction in the caseload, a reduction in benefit levels, or some combination of these. The key question the authors take on is how much, and by what means, spending would fall. They conclude that reductions of between 17 and 25 percent in cash benefits should be expected, along with a reduction in caseloads and in the average length of time people resort to the programs. In some states, the caseload reduction could be quite high, possibly as much as 60 percent in California.

In the federal context, alongside the elimination of matching grants is the potential effect of competition among states. Insofar as welfare induces recipients to migrate in search of higher benefits, states have some incentive to reduce their welfare benefits in a “race to the bottom.” Chernick and Reschovsky evaluate this hypothesis. Finally, the authors provide specific estimates in three states of effects that would result from turning both Medicaid and AFDC into block grants.

The brand of devolution practiced by recent Congresses turns the traditional economic model of federalism on its head. The authors sketch out the standard case for centralizing public programs pertaining to income distribution and aid to the poor. This approach is elaborated at length in Musgrave (1958, 1997), Oates (1972), and Rivlin (1992). The basic idea is that insofar as citizens in one state care about the potential beneficiaries of transfer programs in other states, and to the extent that differences in state benefits induce the migration of prospective recipients, there is a case for a national, uniform system (such as exists for Social Security, Medicare, and Food Stamps). A second-best alternative to a national system is one where the Federal government shares in the financing of state programs.

Behind the volatile and often bitter debates over work incentives, personal responsibility, time limits, and illegitimacy loomed this issue of financing, one whose potential impact is grossly disproportional to the scant attention it received in the public debate.

In gauging the impact of an elimination of matching grant provisions, Chernick and Reschovsky need to consider how AFDC and Medicaid interact with the third major U.S. program in aid of the poor Food Stamps. Food Stamp benefits are reduced if the beneficiary’s oth
er income, including that from cash benefits, increases. Thus the net effect of a change in the welfare benefit on the recipient’s total income depends on the change in Food Stamp benefits. By contrast, Medicaid benefits are an either/or proposition; one is either eligible for the full benefit package or not. Formerly, Medicaid eligibility was automatic for AFDC recipients. Now Medicaid has been uncoupled, but it is still possible for a change in income that includes TANF benefits to render a family ineligible for Medicaid. This in itself is tantamount to a very large “marginal tax rate” for persons in some circumstances.

Past research on the size and composition of the likely effects of changes in matching rates on welfare spending has given diverse results. One neglected source of guidance is the experience with SSI, where the initiation of Federal financing was more or less fully offset by decreases in state support from own-source revenues. A rough calculation suggests that a dollar of increased Federal support only resulted in a 45 cent increase in total spending, so we could say that more than half of the Federal money was recouped by state governments for use in other spending programs or for tax cuts. Thus in the absence of matching, this would imply that roughly half of a block grant for AFDC and Medicaid would be used to replace state revenues for those programs. If, for instance, a state was spending $100 million in total for AFDC, half of which was provided by the Federal government on a 50-50 matching basis, turning the Federal grant of $50 million into a block grant would result in a reduction of the state contribution to $25 million, for an overall spending reduction of 25 percent. By this logic, states with a higher Federal match (up to Mississippi’s 78 percent) would implement an even bigger cut in their own contribution. If Mississippi used half of the Feds’ 78 percent to reduce their own contribution, they would eliminate their own 22 percent share of the old pie altogether.

Added to but distinct from the elimination of matching are the possible competitive effects noted above, which could act to further reduce state contributions to programs for the poor. Chernick and Reschovsky’s reading of the literature and their own work lead them to be skeptical of the competitive factors. They do not see a ‘race to the bottom’ borne out in terms of a convergence of state benefits. Nor are they impressed by available evidence on the inclination of prospective welfare recipients to migrate to states with higher benefits. They do acknowledge the potential political power of appeals to such hypotheses. They also see strong effects from the change in matching rate status.

As noted above, their best estimates are for benefit cuts in the range of 17 to 25 percent, with total spending reductions of 30 percent. They also predict a widening of differences in benefit levels across states, in opposition to the logic of a ‘race to the bottom’ theory. The effect of the matching has been to equalize the cost of welfare among the states to some extent, so its elimination will cause other factors stemming from historical and cultural differences to dominate state decisions.

One mitigating factor would be the extent to which Federal regulations prevent states from diverting welfare expenditures to other purposes. Requirements for “maintenance of effort” in the recent welfare reform are an example. In practice such provisions can have ambiguous interpretations and afford states some latitude for evasion of the ostensible intent.

Chernick and Reschovsky construct estimates of spending effects in three specific states California, Kentucky, and Wisconsin under alternative scenarios. One is what could be understood as a baseline or counterfactual where present policy is assumed to remain more-or-less unchanged. A second is a block grant reform under which state responses are assumed to be relatively insensitive. A third is the result of strong state responses to new block grants.

California has above-average income and welfare benefits, and a relatively low Federal matching rate. The authors find that the range of possible spending reductions under the block grant reform to lie between 12 and 23 percent of the baseline amount. Kentucky, by contrast, has lower income and a higher Federal match. Since it faces a higher increase in its costs of provision (given a lower initial cost due to the higher Federal matching rate), its expected reductions in spending are exceed those of California B between 22 and 30 percent. Wisconsin has spent much on welfare in the past, but it differs from most other states in its aggressive pursuit of radical reform, in the form of its W-2 program. Insofar as the state is able to move people from welfare into its work program, cuts in benefits under the welfare program could be less severe than in other states. At the same time, the costs of operating W-2 could increase, and the state could have difficulty in placing additional, less-qualified persons into jobs. All things considered, the authors expect the block grant reform to cause spending drops of 14 to 24 percent in Wisconsin.

All of these expectations remain in the speculative realm for the moment because caseloads have declined throughout the country, due in large part to the performance of the economy. To some extent, aspects of the reform have enabled or compelled states to undertake discretionary reductions in their caseloads through the use of sanctions on recipients who are found not to follow stipulated state rules for participation in the program. The real test of reform for the fiscal and social health of states will come later, as noted above, when the economy turns sour and when the time limits in the new welfare law begin to compel states to reduce their caseload even further.

Under a block grant scheme, aid is not sensitive to economic changes that cause increasing demands for public assistance. While the new welfare legislation provides for an emergency fund to aid states during dips in the business cycle, Chernick and Reschovsky find the size of this fund wholly inadequate to the likely costs faced by states during the next recession. Placing welfare recipients into jobs is clearly more daunting during periods of relatively high unemployment. Moreover, as noted in other chapters, state revenues also fade at the worst possible time — when spending pressures grow.

The authors conclude that the devolution of welfare to the states violates a basic principle of fiscal federalism and accordingly courts some significant risks. It will be difficult for states to move large numbers of low-skilled persons into the labor market, and difficult to finance any such efforts when they are most needed. Extreme hardship could result from excessive trimming of the welfare rolls in the absence of any expansion of labor market opportunities. Even the presence of such opportunities fails to assure us that the children in such families will end up with improved well being. This welfare reform may not advance the cause of reducing poverty.

Fiscal Disparities and Education Finance
As previously discussed, the chapter by Joseph Persky and Wim Wiewel sets forth the concept of fiscal disparities between city and suburb. The idea may be generalized to all local governments. Urbanization aside, local or state jurisdictions could and usually do have varying levels of taxable resources and public expenditure needs, among other differences. John Yinger elaborates these and other dimensions of the concept in order to motivate and analyze the mechanics of redressing such disparities by means of fiscal equalization grants provided by state government.

Fiscal disparities in education take on an added timeliness in the context of this volume. One reason is that devolution could increase fiscal disparities across and within states. In both cases Federal aid programs aimed at alleviating such disparities have been terminated or reduced over the past two decades. Another reason is
that state court decisions can compel state legislatures and governors to address fiscal disparities if it is found that the state’s constitution requires equal educational opportunity for all. A third reason is that a development-based approach to reducing poverty could logically include a focus on education. Reducing fiscal disparities in education does not preclude any sort of educational reform, whether liberal or conservative. State aid in such a setting could finance anything from vouchers to existing public schools.

The revenue side of the disparity concept should be clear. Residents in different jurisdictions can have different income levels, different levels of taxable real estate, and different consumption patterns, among other things. Jurisdictions have varied capacities to finance any given amount of public expenditure.
Needs and tastes for public spending also will differ. Economists are typically leery of using a term like “need,” since there is a subjective element that they would prefer to describe with more neutral terminology like “taste.” For our purposes we could define need in terms of the resources devoted on average to specific purposes. For instance, there is some average level of education spending for handicapped students in any state. So by that criterion we could say that a locality with 100 such students has a “need” for a specific amount of spending, by average criteria.

In some cases the concept of need will be set forth by fiat, in the form of a mandate or law under which need is stipulated in relatively simple terms. The subjective choice in this situation is made clear at the outset.

The point of constructing a concept of needs in this fashion, or by more sophisticated means, is to enrich a comparison of jurisdictions’ fiscal capacity by considering needs as well as revenue raising. We would like to compare expenditure burdens in jurisdictions by some averaging criteria which, as for revenue raising, is separable from the actual preferences of the jurisdictions’ voters and elected officials.

A third distinction among jurisdictions is variation in the price of goods and services required to provide public services. As for need, this too mitigates against a state’s fiscal capacity. An obvious example is differing labor costs across jurisdictions. As Yinger points out, governments may decide what to pay their employees, but their choices are constrained by labor market conditions not under their control.

A fourth distinction is the realm of what are called ‘environmental factors.’ These are social or other conditions that affect the cost of providing public services. An obvious one is the variability of a jurisdiction’s temperature. A place with temperatures that hover close to a comfortable range will have lower heating and cooling costs than one with extremes of temperature. An example of a social factor would be the incidence of crime in a jurisdiction, since crime raises the costs of providing services.

To have an equalizing effect on local jurisdictions’ fiscal capacities, state aid must correlate positively with ‘cost’ factors (needs, input prices, environmental factors) and negatively with revenue raising assets, broadly speaking. The compact means for determining grant allocations is by means of a formula of some kind that ideally takes all such factors into account by some means or other.

When fiscal capacity is estimated for local jurisdictions in a given state, it can vary widely. Yinger finds that for the state of New York, the capacity of the best-off district is over five times that of the average district, while the capacity of the worst-off district is less than a quarter of the average. Equal education opportunity in such circumstances, where local governments have the primary responsibility for financing public education, is clearly a daunting proposition.

Why consider this to be a problem? As for the city-suburb framework, fiscal disparities are once again a unique case of inefficiency and inequity reinforcing one another, rather than having offsetting roles. Disparities encourage inefficient location decisions, and indulgence of disparities reinforces patterns of income inequality which citizens may consider unappealing. Finally, as noted above, disparities may be found by state courts to render unconstitutional existing systems of education finance that rely solely on local governments’ own-source revenues.

A commitment to fiscal equalization is only the starting point, since many questions remain to be answered. Exactly what is to be made more equal? The discussion of needs, prices, and environmental factors should make clear that spending per pupil is not a good target. A dollar can go a little or a long way, depending on the factors mentioned above.

We would like to reward extra initiative, effort, and performance, whether the recipient is a student, teacher, school, school board, or local government. We don’t want to reward failure, but we also would like to foster improvement in cases of failure. Unfortunately, we cannot measure honest effort and use it as a factor in grant formulas.

Another type of equity goal raised by Yinger is ‘wealth neutrality.’ We might want to ensure that educational outcomes are not affected by the personal wealth of parents in school districts. In keeping with our previous remarks, expenditure is not a good proxy for outcomes since other factors intervene.

Yinger describes specific aid schemes in detail, in line with the considerations summarized above. One common problem is that in practice some of the important cost factors he discusses are neglected or ignored entirely in state aid programs, defeating the basic goal of the exercise. Yinger illustrates the dilemma by using New York State as an example.

A second problem is that the satisfaction of some goals, such as ‘wealth neutrality,’ can require very high levels of aid with politically unlikely differences in what different jurisdictions receive. In fact, under some schemes it could be necessary for jurisdictions to receive ‘negative aid,’ meaning an additional special payment to the state government.

One helpful device is centralization of revenue systems, such as state assumption of the property tax to finance local public education. In conjunction with an aid program geared to expenditure needs, input prices, and environmental factors, a fair amount of equalization can be accomplished.

Yinger also undertakes a brief tour of the fiscal disparity problem outside of local public education. Like Persky and Wiewel, he places importance on fiscal disparities between city and suburb, not least because suburban residents may derive benefits from public services for which they do not pay a proportionate amount in taxes to the city government providing these services.

One interesting problem addressed is the case for Federal involvement in intra-state disparities among local jurisdictions. Under a simplified “Chinese box” model of federalism, also described as “layer cake” federalism, disparities are solely the concern of the next, higher level of government. Cities are responsible for their neighborhoods, counties for their cities, states for their counties, etc.

In practice this model is vulnerable to criticism. Historically, in many cases the politics of state government have not served the interests of the poor honorably, much less well. As Conlan and Riggle point out, our expectations in this area ought to improve in light of evident historical progress in state government capacity. In the past, Federal intervention served as a reliable deus ex machina. Whether it will be needed in the future or whether devolution will be judged inadequate will be grist for vigorous debate. The Yinger chapter provides state governments with tools to cope with Federal retrenchment.

Revenue Sharing as a Public Investment Strategy
There is widespread concern about the state of public investment in the U.S. (Shafer and Faux, 1996). In 1989, h
undreds of economists endorsed a petition decrying the nation’s neglect of infrastructure, education, and training. Granting such a concern, an obvious question is how to pursue an investment program. As noted at the outset of this introduction, most ‘mainline’ public services and facilities are under the purview of the states, although the Federal government has provided important financial leverage. Bruce Wallin provides a partial remedy to the problem.

Chernick and Reschovsky explore in depth the problem of ‘fiscal substitution’ as it applies to block grants for welfare, but the issue is more general. Grants-in-aid that are targeted for particular purposes can have weak or negligible effects insofar as grant recipients are able to shift the resources to purposes they favor. In contrast to the difficulties of designing a grant that changes the recipient’s behavior in a more-or-less specific manner, Wallin inquires into the uses to which a grant for general assistance would be put.

General assistance might be used to expand the recipient’s budget or to replace own-source tax revenue. This question has been studied through the use of statistical methods. Wallin, an expert on the U.S. revenue sharing program (Wallin, 1998), uses survey research methods to attack the problem. He finds strong evidence that no-strings, general assistance would be used by localities for investment in public facilities and public capital in general.

By reference to the political behavior of local government, Wallin offers some explanations to support his empirical finding. Given historical experience, local officials are likely to look upon Federal grants as a windfall with an uncertain durability. The U.S. Congress has proven fickle in other endeavors and the economic future is impossible to predict with confidence. Citizens expect some level of public services indefinitely. Why then use a windfall for capital expenditures, rather than to hire more public employees or cut taxes, both policies with some political appeal?

The answer is the downside risk of a cut-off in aid. Given expectations of a certain level of public expenditures, using the grant to finance a tax cut runs the risk of future deficits, which will require either a tax increase or a spending cut. In the same vein, using a grant to hire additional public employees runs the risk of having to dismiss them if the aid faucet is shut, or else find another source of budget funding.

By contrast, ‘windfall’ aid can be used to buy an indefinite series of bite-sized capital items. There is less political fall-out from a termination of this policy necessitated by a termination of the grant. By the same token, the longer the grant program continues, and the more confidence in its future grows, the more likely it is that the resources will be absorbed into the local government’s routine operations, which means that it will simply come to replace local revenues.

Thus in the short-run, a renewal of the U.S. revenue sharing program would boost public investment at the local level of government. In the longer term it might do no more than alleviate fiscal disparities, but as Yinger points out, there are good rationales for this outcome as well.

Conclusion
States will increasingly take center stage in U.S. social policy as devolution proceeds. A basic task will be the finance of existing commitments, not to mention the new responsibilities assigned by the national government.
A basic finding in these studies is that state economies can accommodate these challenges to a great extent, and state governments have the capacity and tools to cope, but the recent reform of welfare remains problematic. A similar reform of health care could substantially heighten the risks and potential problems faced by the federal system in the future.

As this is being written, state fiscal conditions are sunny and the national economy is steaming along. How devolution will work under less favorable circumstances remains to be seen.

National policy-makers in Congress and the Administration would do well to monitor the welfare reform process closely, particularly in terms of the fate of those who leave, are removed from, or decline to join the welfare rolls. They should keep an eye open for signs of competitive pressure on state tax systems. They should give renewed consideration to opportunities for public investment that have been neglected in the past.

State governments need to heighten their focus on the problem of fiscal disparities, which a variety of factors could exacerbate in the future. They also need to look forward in terms of the future revenue needs implied by the current or prospective policies and reforms voters desire. An obvious threat deserving preparation in the form of ‘rainy-day’ funds is the onset of the next recession.

In the specific, active field of welfare reform, states need to emphasize the objective of reducing poverty as the goal of welfare reform, not the mere reduction of caseloads. Insofar as education is viewed as a solution to poverty, fiscal equalization is an essential task. States also need to be alert to the social and fiscal costs associated with fiscal disparities, or (in the specific area of welfare reform) caseload reduction, so that the true costs and benefits of diverse policy options may be seen clearly and understood.

If federalism is a laboratory, the devolution experiment requires safety goggles. At the very least, devolution ought to be an experiment that affords us a learning experience, so that policy achievements can be replicated, and mistakes not repeated. We hope that readers who observe, participate in, or are the objects of this experiment will benefit from this book.


See related work on Wages Incomes and Wealth

See more work by Max B. Sawicky