Federalism in Blue and Red

Summer 2017

In 2012, Republican governor Sam Brownback and the Republican state legislature in Kansas undertook what would soon be characterized as a radical experiment in supply-side economics. Over the following several years, they reduced the state's progressive income tax from a top rate of 6.45% down to 4.6% and essentially raised the state's sales tax from 5.7% to 6.5%. Grover Norquist and Art Laffer were ecstatic while liberals predicted gloom and doom. Five years later, as revenues plunged and the legislature scrambled to find enough money to fund schools and basic services, liberal pundits around the country let out a collective "I told you so."

Meanwhile, few people noticed that analogous changes were underway in true-blue Massachusetts. In 2009, Democratic governor Deval Patrick and the Democratic state legislature likewise raised the state's sales tax from 5% to 6.25%. Over the following several years, that same legislature — but with Republican governor Charlie Baker — reduced the state's flat income tax from 5.3% to 5.1%. Despite strikingly similar shifts in its tax structure, Massachusetts received essentially no praise from supply-side evangelists or condemnation from liberal pundits. More important, no budget crisis followed. What explains these divergent outcomes following similar tax reforms?

The answer lies in the varying fiscal capacity of each state. Fiscal capacity is the ability of governments to raise enough revenues for the provision of basic public goods. Due to differences in total taxable resources (incomes, natural resources, and the like), some states are able to raise more revenues with less effort. Kansas and Massachusetts are perfect examples of this. Per-capita income in Massachusetts is about $36,600, while it is only about $27,900 in Kansas. Imagine that both states adopt a simplified tax of 5% on all income. Massachusetts would raise $1,830 per capita, while Kansas would raise just $1,395 per capita. In other words, even if Massachusetts and Kansas levied the exact same tax rates on the exact same revenue sources, Kansas would fall significantly short of the revenue collected in Massachusetts.

Nevertheless, the costs of providing basic services — education, law enforcement, social assistance — are not that much lower in Kansas than in Massachusetts. This leaves poorer states like Kansas with two choices: They can keep tax levels competitive with other states at the cost of subpar government services, or they can provide basic services at the cost of higher taxes relative to other states. Neither option is particularly attractive. The unfairness of the situation becomes apparent when you realize that fiscal capacity depends in large part on factors beyond the control of policymakers. Kansas is penalized for being an agricultural state rather than being gifted with natural resources like Wyoming, or endowed by historical luck with exceptional educational institutions like Massachusetts.

Historical accidents should not and need not determine state destinies. Nobel Laureate and famed libertarian economist James Buchanan recognized that such a problem might arise under federalism when substantial disparities existed between the fiscal capacities of states. Buchanan argued that it was an issue of horizontal tax equity, or the equal treatment of taxpayers in similar situations. Imagine a taxpayer living in Massachusetts whose job transferred him and his family to Kansas for an equivalent job. Assume his income and quality of government services remained constant. As a result of Kansas's limited fiscal capacity, he would end up paying higher taxes on the same income, but receiving the same services he had been getting in Massachusetts. Inequities in fiscal capacity become a problem when taxpayers are penalized (or receive a windfall) simply because they live in a state where people are poorer (or richer) on average.

Buchanan's solution was a policy in which the federal government would provide some sort of "equalization grant" to states with below-average fiscal capacity to bring them up to the average across all states. The funds would involve unrestricted block grants, so states would be able to spend them as they saw most fit — including by lowering state and local taxes.

By basing the grant on fiscal capacity, this method addresses several concerns raised by critics of intergovernmental grants. First, the amount of funds for each state is determined by a set formula, reducing the risk of rent-seeking by powerful regional coalitions. Second, it encourages lower taxes but not profligate spending. The grant amounts are limited and go only to states that are already strapped for cash. Thus the incentive for state policymakers is to provide the basic services that are lacking and use the rest of the money to reduce state taxes. Third, it is not based on poverty rates or welfare caseloads. This eliminates the risk that the federal government would become a piggy bank, preventing states from socializing the costs of bad economic policies that increase unemployment.

Critics might concede that this all sounds good in theory, but how do we know states would be fiscally responsible with the money? Canada and Australia, which have administered equalization grants to provinces and states with limited fiscal capacity for decades, provide real-world examples of how states react to these grants. They have successfully enabled poorer regions like Nova Scotia and Tasmania to provide basic services and keep their tax structures competitive with richer regions. There is little evidence policymakers have tried to keep taxes high or have spent money on wasteful programs. Equalization has been tested abroad and has shown itself to be an unimpeachable success.

This raises an obvious question: If fiscal equalization works so well, why hasn't it been adopted in the United States? As Buchanan knew well, there is a difference between optimal policy and the public choices made by real policymakers. In order to understand why proposals for equalization have failed in the past but are ripe for action now, we must look at the politics of federalism in the postwar period. The answer we find is that congressional Democrats from the nation's richest states have obstructed reforms that shift benefits from Western and Northeastern blue states like New York, California, and Massachusetts to Southern and Midwestern red states like Georgia, South Carolina, and Kansas.

Indeed, history reveals that there are actually two competing visions of federalism in the United States — one red and one blue. Red-state federalism means policies that allow poor states the opportunity to provide tax relief for their overburdened residents without sacrificing basic services, while blue-state federalism reinforces fiscal inequities and imposes further burdens on poor-state residents. Dominant narratives about states' rights or overbearing federal officials have overshadowed this history, but it is vitally important to understand it to see the way forward for conservative reform proposals.

MISSED OPPORTUNITIES

Experts and public officials have known for decades that some states have limited fiscal capacity relative to others. All the way back in the 1938 Report on Economic Conditions of the South, for instance, a federally appointed committee observed that limited fiscal capacity meant that "[t]he South must educate one-third of the Nation's children with one-sixth of the Nation's school revenues." Federal officials noted this was not for lack of effort: "All Southern States fall below the national average in tax resources per child, although they devote a larger share of their tax income to schools."

Numerous federal reports in that era came to similar conclusions. Until recently, historians of federalism have largely ignored these reports. Instead, they have portrayed Southern policymakers as so zealously anti-tax or anti-spending that they would sacrifice the well-being of their constituents in the name of conservative ideology. The truth, increasingly recognized by historians and sociologists, is that Southern and Midwestern policymakers were tasked with the impossible job of spending like rich states with the limited resources of poor states.

These fiscal inequities were worsened by the New Deal. The Social Security Act of 1935 made states responsible for the provision of social assistance for the elderly, the disabled, and children. The federal government assisted states through the use of matching grants. Every dollar spent by states on these benefits would be matched by a dollar from the federal government. At first glance, this does not seem like a bad deal. In practice, it put poorer states at a disadvantage. It was rich states, with their higher fiscal capacity, that could afford to spend more on benefits. For this, they were rewarded with a higher proportion of federal funds. Poor states could not afford to be so generous and were left with a lower proportion of federal funds as a result.

President Roosevelt's landmark reforms thus ensured that rich states got richer and poor states stayed poor. In 1940, Governor E. D. Rivers of Georgia warned of the "increasing and continuing relief burden beyond the fiscal capacities of states and local governments," but efforts to adjust the grant formula were met with opposition from "progressive" members of Congress representing rich states. They resented the idea of Southern and Midwestern states receiving more federal funds if their own states did not get a piece of the pie as well.

Mobilization for World War II temporarily put state issues on the backburner, but Southern and Midwestern governors revisited the problem after the war. At the 1947 meeting of the National Governors Association, Governor Frank Carlson of Kansas proposed a resolution calling on Congress to provide equalization grants to states with limited fiscal capacity. The governor of what was, at the time, wealthy Indiana criticized the resolution because it provided no benefits to rich states. By the time the resolution was voted on and passed, it was so watered down that it had become unrecognizable. The governors of poor states continued to press for equalization in subsequent NGA meetings but found themselves facing criticism from the governors of rich states every time.

Soon, the governors of Georgia, Florida, and South Carolina joined Kansas in calling for another resolution in favor of equalization, explicitly on the grounds that their states had limited fiscal capacity to raise the revenues necessary for a minimum level of services. The governor of wealthy New Jersey joined in the opposition, and the results were more vague resolutions that failed to mention equalization at all.

As other federal countries, such as Australia and Canada, increasingly recognized the problem of limited fiscal capacity and responded by introducing equalization programs, the United States remained indifferent to the plight of its poorer states. The reason was simple: Rich states repeatedly blocked equalization proposals coming out of the South and Midwest. State governors have proven to be powerful political actors able to push for federal changes when they work together. But the absence of this unity has been the Achilles' heel of equalization. Without the support of governors representing rich blue states, the movement for equalization was left fragmented and ineffective.

Budget pressures eventually led the states to join together to push for a broader program of revenue sharing beginning in the late 1960s. They succeeded in lobbying Congress and the Nixon administration to introduce revenue sharing in 1972. Rather than benefiting states with low fiscal capacity, though, the formulas used to allocate funds were shaped by powerful Northeastern governors and big-city mayors. Benefits subsequently flowed to some of the richest regions in the country. Much like the Social Security Act of 1935, the program that passed did absolutely nothing to reduce interstate inequities in fiscal capacity. When President Reagan rightly killed the revenue-sharing experiment in 1986, Democrats accused him of callously cutting funding for society's most vulnerable. The irony that this program, like those before it, was explicitly designed to benefit wealthy New York (including New York City's infamous "welfare mess") instead of struggling Mississippi never crossed their minds.

SUBSIDIZING THE RICH

The continued absence of equalization in the U.S. stands in stark contrast to the growth of what was once a relatively obscure tax deduction. The original legislation enacting the federal income tax in 1913 included a provision allowing individuals to deduct the cost of state and local taxes from their federal tax liability. This was supposed to prevent double taxation of business as well as reduce competition between the federal and state governments for revenues. Although initially claimed by most taxpayers, the introduction of the standard deduction in 1944 meant that only high-income earners who itemize on their tax returns could claim it in subsequent years. Last year alone, the state and local tax (SALT) deduction cost the federal government over $90 billion of forgone revenue.

High-spending states have grown to love the SALT deduction for self-interested reasons. As Louis XIV's finance minister, Jean-Baptiste Colbert, famously claimed, "The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing." By allowing rich taxpayers to deduct the cost of their state and local taxes, high-spending states could pluck more feathers with less hissing. The deduction enables states to increase taxes while letting the federal government pick up the tab for it through revenue losses at another level. According to the Congressional Budget Office, "By lowering the net cost of certain state and local taxes, the taxes-paid deduction encourages state and local governments to impose higher taxes and to provide more services than they otherwise would." In contrast to equalization, which encourages poor states to reduce their taxes while still providing key services, the SALT deduction encourages rich states to increases taxes and spending above and beyond an already excessive level.

Economists recognize that the SALT deduction is bad tax policy for a number of reasons: It's an inefficient use of federal fiscal policy; it distorts state and local budget decisions; and it subsidizes high-income earners in the country's richest states. Residents of two states alone — California and New York — claim one-third of the deduction's benefits. The economists at the Treasury Department in the Reagan years certainly shared this critical view when they made the decision to target the SALT deduction for elimination as part of the 1986 tax reforms.

Eliminating an inefficient, regressive tax break in exchange for a broader base and lower tax rates should have been a no-brainer, but a coalition soon arose to oppose the proposal. The defenders of the SALT deduction turned out to be a "who's who" of progressive Democrats — Mario Cuomo, Thomas Downey, Daniel Patrick Moynihan, and Charlie Rangel. The New York delegation strung together a broad group of blue-state policymakers and labor groups to successfully force the Reagan administration to drop the proposal from the reform bill. It seemed progressive Democrats had no problem with tax breaks for the rich as long as they benefited blue-state governments and constituencies.

Since 1986, several tax-reform proposals have targeted the SALT deduction for elimination. Each and every time, representatives of rich blue states have come out of the woodwork to criticize them. The reason is purely political. The states that would be hit hardest by the repeal read like a list of electoral-college votes won by Hillary Clinton: New York, New Jersey, California, Massachusetts, Connecticut, Maryland, and Illinois. They are also states where the typical resident makes much more than the national average.

In other words, Democrats continue to defend a regressive tax subsidy that showers most of its benefits on people in states that need it the least. The hypocrisy looks all the worse when you realize that these are the same states that have historically blocked equalization proposals to assist taxpayers in poor states that lack anything close to the fiscal capacity of rich states.

TIME FOR EQUALIZATION?

The results of the 2016 election represent a unique opportunity to remake American federalism based on conservative principles. Speaker Paul Ryan's "A Better Way" initiatives have focused on making the system more efficient and encouraging states to innovate, but they have so far failed to address the unfairness inherent in our current model of blue-state federalism. The advantages of devolution are clear but unlikely to materialize in the absence of a strong program of equalization. Canada offers a glimpse of what red-state federalism could accomplish with equalization.

In contrast to the U.S., where block grants make up just over 1% of the federal budget, they account for about 25% of the federal budget in Canada. Moreover, the largest of these block grants are for the same consolidated functions Speaker Ryan has proposed here — health care and social assistance. The key difference is that Canada's robust system of interprovincial equalization complements its system of block grants so that residents of poor provinces are not unfairly burdened with higher taxes. A similar system, which the advocates of a "New Federalism" could only dream about in the past, is now within reach in the U.S.

Historically, rich states and their Democratic representatives in Congress have been the biggest obstacles to the introduction of equalization. The recent election ushered in complete Republican control of the House, a Senate majority, and a Republican presidency for the first time in a decade. The little-noticed but perhaps more important story is that the same partisan transformation has been taking place in state capitals for the past several years. Republicans now dominate on the state level with control of both the legislative and executive branches in 24 states. Nine further states have Republican governors and another eight have Republican-controlled legislatures. Democrats have unified control of only seven states. Just as partisanship has trumped a more equitable fiscal federalism for decades, today's Republican control of the federal and state governments offers the chance to correct this historical injustice. Republicans should use this opportunity to replace the SALT deduction with an equalization program.

The SALT deduction is a prime candidate for elimination for several reasons. First, rather than rewarding fiscal responsibility, it incentivizes higher taxes by shifting some of the cost from the state to the federal government. State policymakers face less opposition to raising taxes because some taxpayers know they can recover that money by deducting it from their federal taxes. Second, since only high-income earners who itemize qualify for the deduction, it allows the rich to escape the cost of increased state taxes but not middle- and working-class earners. Warren Buffett, for example, was able to deduct $2 million for New York state income taxes paid. It is likely his secretary was not able to claim any benefit from it at all.

Finally, the SALT deduction reinforces regional inequities, providing disproportionate benefits to those in rich states. It is worth almost 11 times as much to the average beneficiary in high-fiscal-capacity Connecticut as it is in low-fiscal-capacity Tennessee. Although there will be pushback from the usual suspects, Republicans must take seriously David Stockman's well-known advice to President Reagan: Attack weak claims, not weak claimants. Eliminating the SALT deduction is the fairest way to provide the funds necessary for equalization without increasing the deficit one penny.

Based on 2012 estimates (still the most recent available), a full program of equalization — one that brought the 27 states with below-average fiscal capacity up to the national average — would cost close to $121 billion. According to the Joint Committee on Taxation, the total value of the SALT deduction only reached $68 billion that year. In light of current deficit projections, replacing the deduction with an equalization program of that magnitude would be fiscally irresponsible, increasing the deficit by tens of billions of dollars per year.

But a smaller program, with grants equal to 50% of the amount necessary to bring those same states up to the national average, would still go a long way toward rectifying fiscal inequities and reduce the deficit by billions of dollars each year. It would be up to future policymakers to revisit the formula as fiscal conditions improve.

The chart below lists the states that would receive equalization grants under this proposed system.

Of the 24 states that currently have a Republican trifecta in their state capitals, 19 would receive equalization grants under this proposal. Unlike most block grants, equalization grants would come without any strings attached. State policymakers with knowledge of local needs — not Washington bureaucrats — would determine the best use of funds. Kansas, for instance, could avoid its current situation, in which it is being penalized for enacting pro-growth tax reforms, by using funds to close the short-run budget gap. Tennessee, which has some of the highest sales-tax rates in the country, could provide tax relief for working-class families most in need. Utah, which comes in last in terms of K-12 spending per pupil, could boost education spending as it saw fit rather than simply complying with federal mandates. The responsibility for setting state priorities would shift back to the states where it belongs.

THE NEXT PHASE OF FEDERALISM

Almost half a century ago, President Nixon called for a "New Federalism" to reverse the trend toward centralization that had been progressing since the New Deal. Despite its initial promise, though, New Federalism has not had an easy road. Nixon's revenue-sharing proposal, for example, was met with near-instant opposition from rich-state Democrats.

But the Republican revolution of the 1990s brought us the Unfunded Mandates Reform Act and the Personal Responsibility and Work Opportunity Reconciliation Act, both of which shifted power from the federal government back to the states. And more recent developments show even more promise: Speaker Ryan's A Better Way initiatives, which propose to consolidate and convert several social-assistance programs and Medicaid into block grants for the states, have the potential to fulfill the original vision of the New Federalism. In order to succeed, though, a program of fiscal equalization would need to accompany any such reforms.

As the Canadian case demonstrates, block grants for social assistance and health care have several benefits over the current system. Unlike matching grants, which require states to contribute some fixed percentage based on a formula, block grants do not put low-fiscal-capacity states at as great a disadvantage because they have fewer resources. This disadvantage does not disappear with block grants, however; fiscal pressures still exist, and this can lead policymakers to treat block grants as a rainy-day fund for unrelated programs. We have seen this in recent years with the Temporary Assistance for Needy Families block grant. State policymakers were supposed to use the funds in innovative ways to move people from welfare to work quickly and efficiently, but low-fiscal-capacity states have siphoned off some of the funds for use in programs that, though praiseworthy and important, have little to do with encouraging self-sufficiency. Advocates for the poor fear that increasing reliance on block grants means society's most vulnerable will lose out. Rich-state Democrats portray this as mean-spirited Republicans taking money from the poor, ignoring the fact that limited fiscal capacity necessitates tough choices for poorer states.

One of the benefits of equalization is that it indirectly enables the sort of experimentation and innovation envisioned by the architects of the 1996 welfare reforms. Since equalization would help reduce general budget pressures in low-fiscal-capacity states, policymakers in those states would lose the incentive to siphon off funds from TANF to pay for normal budget items. Louisiana, for example, could use equalization funds to reduce taxes and provide college scholarships, allowing the state to fully dedicate TANF funds to effective welfare-to-work reforms. If Speaker Ryan's proposals to block-grant additional programs become policy, low-fiscal-capacity states will require equalization grants to allow them to fruitfully innovate in those areas as well.

Additionally, equalization encourages further decentralization by limiting the federal overreach that occurs in the form of the strings now attached to most federal grants. All too often, federal bureaucrats exercise control over state programs by sneaking onerous regulations into categorical grants. As an unrestricted block grant, equalization would free poorer states from the coercive power of federal mandates. States could once again become laboratories of democracy with the freedom to do what is best for their residents rather than for powerful lobbies in Washington.

A PRECONDITION FOR MEANINGFUL FEDERALISM

History has shown us that the freedom to spend according to state prerogatives is not enough to entice even poorer states to support devolution. Limited fiscal capacity has hindered previous decentralization proposals. President Reagan's once-famous proposal to "swap" federal responsibility for Medicaid in exchange for full state responsibility for welfare and food stamps was derailed when it lost the support of conservative governors representing states with limited fiscal capacity. More recently, Benedic Ippolito of the American Enterprise Institute has described the question of how to ensure that poor states are not hurt by proposed block-grant formulas as the "elephant in the room" for Medicaid reform. Without equalization, Ryan's block grants for social assistance and health care will become just another partially funded mandate putting red states at a disadvantage — in which case not even Republican dominance at the state level will prevent opposition arising from Southern and Midwestern governors.

Conversely, Canada's equalization program allowed the federal government to pursue a far-reaching program of decentralization and deficit reduction in the 1990s by assuring poorer provinces that they would not disproportionately bear the costs of the reform. Canada's impressive reforms made it the envy of deficit hawks and advocates of decentralization south of the border. But too few realize the key role played by equalization in enabling these reforms. No equalization, no reform.

For far too long, American policymakers have let the stereotype of red-state stinginess drive policy decisions while ignoring blue-state greed. Instead of asking, "What's the matter with Kansas?" we should be asking, "What's the matter with New York?" It is time for conservatives to take control of the narrative and begin taking active steps to end the injustices of blue-state federalism. The first step in this new agenda is the most crucial: Repeal the state and local tax deduction and replace it with an equalization program.