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6.3

2.8

3.2

0.3

Foodstamps-administration

0.8

0.2

0.6

0.5

Childnutrition/special milk programs

0.6

1.4

1.3

1.2

Housingassistance

0.7

1.4

2.5

2.9

Veteransbenefits and services

0.0

0.0

0.0

0.0

Administrationof justice

0.1

0.2

0.1

0.5

Generalgovernment

0.7

3.4

0.6

0.3

Grant-in-aid SharedRevenues

36.4

36.6

35.3

35.9

(b) Income Redistribution30

Another large categorical matching grant isdirected towards assistance to low income families. Aid to Families withDependent Children (AFDC) was introduced in 1935 and was replaced in 1997 witha block grant program entitled Temporary Assistance for Needy Families (TANF).AFDC was a joint federal and state program, as is TANF. States administer theprogram and set benefit levels. The federal government provides one-half tothree-quarters of the financing, depending on a state’s per capita income.

The Medicaid program described above is alsoaimed at redistributing income. It provides medical care to the poor(especially children), the aged in nursing homes, the blind, and the disabled.Prior to the reform of AFDC in 1996, all families receiving benefits under AFDCwere entitled to Medicaid. Today, states are required to provide Medicaid tofamilies who would have been eligible to receive benefits under AFDC. Inaddition, the Children’s Health Insurance program (CHIP) was introduced in 1997 andprovides funds to states to provide health care for children with familyincomes below 200% of the federal poverty threshold.

(c) Education

The federal government provided nearly 10%of the funding for education in 1996 in grants-in-aid to state and localgovernments. Federal aid, however, is directed primarily toward specialprograms for the disadvantaged, children and family services, and training andemployment assistance. The bulk of expenditures for elementary and secondaryschools and higher education are financed by state and localgovernments.

(d) Transportation

The federal government providesgrants-in-aid to state and local governments for transportation, which includesairports, highways, and urban mass transit. Close to 80 percent of federalfunding for transportation in 1996 was directed towards highways. Federal fundscomprise nearly 25% of state and local expenditures on highways. The federalgovernment assists in highway funding by contributing to the states’ highway trust funds.

(e) Housing and CommunityDevelopment

Federal grants to state and localgovernments for housing and community development comprised nearly 70% of stateand local funding in 1996. The funding is distributed by the Department ofHousing and Urban Development (HUD). Close to half of the funding from HUD isdirected towards lower income housing assistance and, thus, can also be groupedwith the federal government’s income redistribution programs.

2. Conditional Block Grants

Conditional block grants are funds providedfor expenditures incurred within a general functional area such as welfare orhousing. There is no matching component. They allow greater discretion for howfunds are spent than do categorical grants. The states and local governmentsgenerally prefer the added flexibility of block grants. In addition,regulations for block grants tend to be shorter and simpler than forcategorical grants. Critics of block grants argue that there is less adherenceto standards, less oversight of grant monitoring, and that they provide lessassistance to poorer segments of the population.

In the past thirty years, there has been amovement towards converting categorical grants into block grants. For example,in 1971, 129 categorical grant programs for education, law enforcement,community development, urban development, manpower training, and transportationwere converted into 6 block grants. Again in 1981, 57 categorical grants wereconverted into 9 block grants. As noted above, in 1997 one of the largestcategorical matching grant, Aid to Families with Dependent Children, wasconverted into a block grant entitled Temporary Assistance for NeedyFamilies.

3. General-Purpose Grants: General RevenueSharing

A program of general revenue sharing wasenacted in 1972 under the State and Local Fiscal Assistance Act. The programprovided funds for state and local governments to spend at their discretion.From 1972 to 1980, states received one-third of the funds and local governmentsreceived two-thirds. In 1980, states were removed from eligibility in theprogram and the program for local governments was terminated in 1986. There isnow no general-purpose grant program in the United States.

4. Tax Deductions

Historically, Congress allowed deductibilityof most state and local taxes from federal income tax. Today, only income andproperty taxes are deductible, and limitations on this have also been imposed.Tax deductibility allows state and local governments to raise their taxeswithout the full burden falling on their citizens. In essence, then, taxdeductibility is a form of financial assistance from the federal government tothe state and local governments.

5. Tax-Exempt Municipal BondInterest

Interest income from state and localgovernment bonds are exempt from federal taxation. This provision essentiallylowers the rate of interest that state and local governments pay on borrowedfunds. To the extent that the proceeds from issuing debt are used to financegovernment services such as education, policing, etc, this provision providesanother means through which the federal government helps finance servicesprovided by subnational governments.

6. Federal Mandates

Often, the federal government mandates thatsubnational governments undertake specific activities or provide specificservices. Examples of federal mandates are the removal of asbestos from schoolbuildings, the filtering of drinking water, and access by the disabled topublic buildings and public transportation. While state and local governmentsoften support these regulations, they are expensive and the federal governmentoften does not provide the funds needed for their implementation. Theimposition of unfunded mandates’ by Congress has been highly controversial.

7. Threats of Loss of Funds

The federal government sometimes threatensthe loss of funds if state and local governments do not comply withcongressional statutes. For example, in 1974 Congress wanted the official speedlimit on highways to be reduced to 55 miles per hour. To ensure that statescomplied with this reduction, the federal government threatened to remove 10%of a state’s highwayaid funds if it did not reduce the speed limit. Other examples where threats ofloss of funds have been employed are allowing right turns on red lights,raising the minimum age to purchase alcohol, and implementing affirmativeaction programs.

The Need forIntergovernmental Transfers

There are varied opinions on the need forintergovernmental transfers. Those in favour of transfers point to the improvedefficiency and equity that results from assigning superior taxing powers tohigher levels of government while assigning greater spending responsibilitiesto lower levels of government. Those against transfers argue thataccountability and efficiency suffer when lower levels of government areprevented from raising the revenues needed to finance programs designed torespect the preferences of their citizens. Complete decentralization of tax andexpenditure powers, however, can result in inefficiencies and inequities, whichmay be corrected by utilizing intergovernmental transfers.

1. Correcting for externalities

Many government services impart benefits andcosts that reach beyond municipal or state boundaries. For example, educationcreates positive externalities when educated citizens relocate to other regionsof the country. Another example is when citizens who travel from otherjurisdictions benefit from a state highway system. If these positiveexternalities are not taken into account by lower-level governments, then toolittle spending is undertaken. Intergovernmental transfers can correct forthese inefficiencies. As well, it can be argued that government services thataffect citizens across jurisdictions should conform to some type of uniformstandards. Consequently, when conditions are attached to the transfers, theypersuade subnational governments to implement programs that adhere to nationalstandards.

Subnational governments can also enter intocompetition with each other in attracting certain types of individuals andbusinesses and discouraging others from moving into their jurisdictions. Forexample, because individuals and business activity are mobile across thefederation, a state or local government may be reluctant to implement aprogressive tax system or a generous welfare or health care program.Intergovernmental transfers can then be used to persuade subnationalgovernments to implement national redistributive policies.

2. Correcting for Vertical FiscalImbalances

The mobility of people and business activitycreates a rationale for assigning a greater responsibility to higher levels ofgovernment in raising tax revenues from mobile tax bases. In the United States,the federal government dominates the personal income tax, corporate income tax,and payroll tax fields. The state and local governments rely mostly on salesand property taxes. In addition, the federal government can resort to deficitfinancing much easier than can states and local governments. As a result,federal receipts have traditionally grown faster than state and local revenues.Furthermore, demand for state and local government services has grownconsiderably. These two facts have resulted in a vertical fiscal imbalancewhereby federal revenues exceed federal expenditures (excludingintergovernmental transfers) and state and local government expenditures exceedtheir tax revenues. Similarly, the limited taxing ability of local governmentshas resulted in a large vertical fiscal imbalance between states and localgovernments. Intergovernmental transfers correct for vertical fiscal imbalancesand offer subnational governments the ability to provide more and bettergovernment services.

3. Correcting for horizontal fiscalimbalances

In the United States, there is considerablevariation in the abilities of state and local governments to raise revenues tofinance their expenditures. The ability to raise revenues is defined as thegovernment’s fiscalcapacity. Differences in fiscal capacity are especially prominent among localgovernments. Thus, poor jurisdictions must levy higher tax rates than richjurisdictions in order to provide the same level of services. Furthermore,there is considerable variation in the need for and the costs of certain typesof expenditures across jurisdictions. For example, some states ormunicipalities may have a larger proportion of elderly or poor individuals.Inefficiencies arise when individuals make their location decisions based onhorizontal fiscal imbalances. Intergovernmental transfers can correct for thesehorizontal inequities.31

Programs Mainly Focused onVertical Fiscal Imbalances

Vertical fiscal imbalances arise whenrevenues of higher-level governments exceed their spending responsibilities(excluding intergovernmental transfers). As described earlier, the federalgovernment has superior taxing powers than the state and local governments. Atthe same time, the states and local governments are responsible for providingnumerous government services. The combination of these two facts result in avertical fiscal imbalance among the three levels of government.

In order to correct for vertical fiscalimbalances, a General Revenue Sharing program was implemented in 1972, but wasterminated in 1986. It is the only program in the United States that had, as amain purpose, the correction of vertical fiscal imbalances.32 The programprovided funds for state and local governments to spend at their discretion.Two formulas were employed to determine the amount of funds a state wouldreceive. The House of Representatives’ formula was based on population,urban population, per capita income (inversely), state income tax collections,and tax effort. The Senate’s formula was based on population, per capita income (inversely),and tax effort.33 The state would receivewhichever formula provided the highest transfer. The formula used fordetermining the amount of funds a local government would receive was based onpopulation, per capita income (inversely), and tax effort. From 1972 to 1980,states received one-third of the funds and local governments receivedtwo-thirds. In 1980, states were removed from eligibility, leaving transfersonly to local governments. The program for local governments was terminated in1986.

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