Mandatory and Discretionary Grants. Grants to state and local governments for health spending stand out not only for their size, but also because they are over-whelmingly classified as mandatory spending, meaning that budget authority for those programs is provided by laws other than appropriation acts (see Figure 3). Some mandatory programs are also so-called entitlement programs, with spending controlled by the eligibility and benefit criteria established in the programs’ authorizing legislation. [Funding for some entitlement programs, such as the Supplemental Nutrition Assistance Program (SNAP), is provided in annual appropriations. (Although state governments administer SNAP, it is not primarily a grant program, as federal benefits are paid directly to individuals without passing through the state governments.) The amount appropriated each year is intended to cover the cost of providing benefits to all people who apply for the program and are eligible; it includes a reserve to cover unexpected costs. But if the appropriated amount does not cover those costs, either lawmakers must provide additional funds or the Department of Agriculture must reduce benefits. There is a diverse set of mandatory grant programs that are not entitlement programs, including, for example, TANF and some wildlife restoration programs.] For example, people may enroll in Medicaid if they meet the eligibility criteria established by their state, and as people enroll and consume health care, the federal government has a legal obligation to pay a share of those benefits (the share varies from state to state). Outlays for mandatory grants totaled $372 billion in 2011, of which $284 billion was for health and $88 billion was for other purposes.
Except in the health area, most federal grants to state and local governments are classified as discretionary spending, which is provided for and controlled by annual appropriation acts. In the annual appropriation cycle, the Congress decides how much funding each discretionary program has available to obligate or legally commit to spend. In 2011, outlays for discretionary grants totaled $235 billion, of which $226 billion was not related to health and only $9 billion was for health programs.
Projections for the Next Decade
The Congressional Budget Office (CBO) projects that federal spending for mandatory intergovernmental grants will be increasingly dominated by Medicaid, which will continue to grow as a share of the economy over the next decade. Specifically, CBO estimates that federal spending for Medicaid will be 2.2 percent of GDP in 2023, an increase of about one-fifth from its 1.8 percent level in 2011. Provisions of the Affordable Care Act (ACA) will contribute to that growth by expanding eligibility for the program in states that choose to participate. [See Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2013 to 2023 (February 2013), www.cbo.gov/publication/43907. The ACA encompasses the Patient Protection and Affordable Care Act and the health care provisions of the Health Care and Education Reconciliation Act of 2010 as well as, in the case of this document, the effects of subsequent related judicial decisions, statutory changes, and administrative actions.] The ACA also introduced a number of new grants, for example, to help states set up insurance exchanges, review health insurance premium increases, and expand consumer assistance programs. At the same time, total spending on grants for major income security programs—TANF and child nutrition programs, for example—are projected to account for a smaller share of GDP in 2023 than they did in 2011.
Other Federal Support for State and Local Governments
The federal government also provides financial support to state and local governments through the tax system. That support takes the form of tax credits or deductions that make it less expensive for state and local governments to borrow money or to raise revenues through taxes. [For more details, see Statement of Frank Sammartino, Assistant Director for Tax Analysis, Congressional Budget Office, before the Senate Finance Committee, Federal Support for State and Local Governments Through the Tax Code (April 25, 2012), www.cbo.gov/publication/43047.] For example, state and local governments can issue bonds for which the interest income is exempt from federal taxes. As a result, those governments are able to borrow money more cheaply than they otherwise could. In 2011, tax-exempt bonds resulted in an estimated cost to the federal government of $30 billion in forgone revenues. [Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2011–2015, JCS-1-12 (January 17, 2012). The estimate for tax-exempt bonds does not reflect the exclusion of interest from qualified private-activity bonds issued by state and local governments. Interest from most private-activity bonds is subject to the individual alternative minimum tax.] Similarly, individuals who itemize deductions on their federal returns are able to deduct state and local income taxes, sales taxes, and personal property taxes from their taxable income. The resulting reduction in federal income tax liability from those deductions was estimated to be $67 billion in 2011. Together, those tax expenditures were about one-sixth as large as the $607 billion in federal spending for state and local grants that year.
Rationales for Intergovernmental Grants
A number of different rationales can explain federal policymakers’ decisions to provide funding for intergovernmental grant programs:
- Such programs can increase economic efficiency in instances when state and local governments have localized knowledge that would allow them to implement a program more efficiently and effectively than the federal government could, but they lack an incentive or funding to provide as much of a good or service as would be desirable from a national perspective;
- The federal government is better able to redistribute resources in the economy;
- The federal government can borrow money more readily than most state or local governments so it has greater ability to stabilize a weak economy;
- Intergovernmental grants can be used as a tool to influence the policy priorities of state and local governments; and
- Intergovernmental grants can encourage state and local governments to innovate or experiment with new programs and activities.
Those rationales for establishing grant programs are not mutually exclusive. Although they are often cited in the literature on grants, they may be more or less relevant to individual programs.
Economic Efficiency
From the point of view of economic efficiency, decision-making authority is best placed with those who have the information and the incentive to weigh all of the benefits and costs of such decisions. Whether the federal government or state or local governments make more efficient decisions in particular circumstances depends in part on who benefits from those decisions and who bears the costs.
State and local governments typically provide certain goods or services for which the beneficiaries are concentrated locally. In such cases, state and local governments tend to be better informed about both citizens’ priorities and local conditions. [The ability of local governments to provide goods and services in the amounts preferred by their citizens also allows individuals to move from one community to another to find the mix of goods and services that best matches their own preferences. See Charles M. Tiebout, “A Pure Theory of Local Expenditures,” Journal of Political Economy, vol. 64, no. 5 (October 1956), pp. 416–424.] If federal policymakers have a goal in mind (for example, to foster community development) but do not have sufficient information to implement that goal at the state or local level, they may turn to grants to take advantage of the additional information available at the state and local level.
However, if some or most of the benefits of an activity extend outside a state or local area, then state and local governments would tend to underinvest in that activity. Under those circumstances, it would be efficient for the federal government to provide funds to state and local governments to encourage them to invest more. For instance, a highway that would serve as a main thoroughfare through a state might benefit surrounding states or even the nation as a whole, not just the state’s residents, but the local benefits it provides might not be sufficient for the state to justify building or improving the road entirely with its own funds. Then, federal support for that road can lead to a more efficient outcome. [See Jeffrey Petchey and Garry MacDonald, “Financing Capital Expenditures Through Grants,” in Robin Boadway and Anwar Shad, eds., Intergovernmental Fiscal Transfers: Principles and Practices (Washington, D.C.: World Bank, 2007), pp. 425–451.] When projects are likely to provide both local and national benefits, the state or local government that receives a federal grant is often required to partially match the federal funding. Though a matching requirement may be intended to recognize that a program has local benefits, the required matching rate does not typically depend on the share of benefits that accrues to localities or to entities outside of those localities.
Intergovernmental grants may also affect efficiency through their administrative costs. Structuring programs so that they are funded partially or solely with federal grants and implemented by state and local governments raises questions about whether involving multiple levels of government leads to the duplication of administrative expenses and higher auditing or compliance costs. Alternatively, using grants may allow the federal government to take advantage of state and local governments’ existing administrative infrastructure and avoid adding a separate federal layer. (For additional information on the costs involved with federal grants, see Box 2.)
Redistribution of Resources
Federal grants to state and local governments may also be used to reduce perceived inequities among certain communities or individuals. In particular, grant programs may serve to redistribute resources by paying for health care coverage, food, or housing for low-income individuals and households. Many federal grant programs— such as Medicaid, CHIP, TANF, and Title I grants for the education of disadvantaged children—redistribute resources. Those and other programs provide federal funds to state and local governments to encourage those governments to implement programs that meet certain national standards. If states or localities opt not to accept such federal funds, their residents could end up paying federal taxes that support benefits they do not receive while residents of other states do.
If, in the absence of federal grants for programs that are intended to reduce income inequality or redistribute resources, some state and local governments attempted to finance those programs entirely on their own through higher taxes or fees, individuals might leave those areas to seek jurisdictions with a lower tax burden and smaller redistribution programs. People who would not expect to directly benefit from the government services their tax payments financed might be especially likely to depart, leaving behind those who expected a net benefit from the programs that aimed to improve equity or redistribute resources. Because moving to avoid federal taxes is usually more difficult than moving to avoid state or local taxes, the federal government is better able to redistribute resources by collecting taxes and funding both fully federal programs and intergovernmental grants that finance programs administered by state and local governments. [See Wallace E. Oates, “An Essay on Fiscal Federalism,” Journal of Economic Literature, vol. 37, no. 3 (September 1999), p. 1125.]
Economic Stabilization
Federal programs that provide grants to state and local governments may serve as automatic stabilizers if spending on those programs increases when the economy contracts or decreases when the economy expands without requiring any new action on the part of the government. [A number of other federal spending programs function as automatic stabilizers, though they are not intergovernmental grant programs. Those include the SNAP and regular unemployment insurance. For more information, see Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2012 to 2022, Appendix C (January 2012), www.cbo.gov/publication/ 42905.] In particular, grant programs with open-ended funding commitments tend to dampen the peaks and troughs of the business cycle if their funding increases automatically when the economy weakens and decreases automatically when the economy strengthens. That is true, for example, if spending rises to keep pace with rising enrollments when the economy worsens and declines in line with enrollments when people’s circumstances improve. [Glenn Follette and Byron Lutz, Fiscal Policy in the United States: Automatic Stabilizers, Discretionary Fiscal Policy Actions, and the Economy, Finance and Economics Discussion Series 2010-43 (Federal Reserve Board, 2010).] State and local governments are typically constrained in their ability to borrow by their state constitutions or state law, so additional federal grant funds that arrive automatically may be especially useful in allowing state and local governments to maintain their activities during an economic downturn. [The federal Medicaid program serves as an automatic stabilizer, but because of its matching requirements, the growth in Medicaid that occurs when a larger portion of the population becomes eligible for the program in an economic downturn also places an added demand on state budgets at the same time that state tax collections decrease.]
In contrast, grant programs for which funding is not open-ended are less well equipped to serve as automatic stabilizers. Funding for TANF, for example, was set in its authorizing legislation at a predetermined level that does not vary over time, so the program is not able to provide assistance to all who may become newly eligible when the economy slows. Discretionary intergovernmental grants, such as those included in ARRA, can also stabilize the economy, though they must be approved by lawmakers and so cannot respond as quickly to changing economic conditions.