Academic journal article Economic Inquiry

The Political Economy of New Deal Fiscal Federalism

Academic journal article Economic Inquiry

The Political Economy of New Deal Fiscal Federalism

Article excerpt

In 1930, the average American received somewhat more than 50 percent of his government services from local government, 20 percent from state government, and the remainder from the federal government. By 1940 this pattern had been reversed, with the federal government supplying roughly 50 percent, state government, 20 percent, and local government, 30 percent. Figure 1 shows how shares of non-military expenditures by the three levels of government shifted dramatically away from local governments toward the national government during the decade. The same was true of revenues. This transition in the relative importance of state, federal, and local government was dramatic and, from the perspective of the 1990s, permanent.

[FIGURE 1 OMITTED]

The most important cause of the shift, in fiscal terms, was the implementation of national relief programs under the New Deal: the Federal Emergency Relief Administration (FERA), the Works Progress Administration (WPA), the Social Security programs, and others. Between 1932 and 1940 direct relief expenditures account for roughly 45 percent of the growth in national expenditures, 60 percent of the growth in state expenditures, and 20 percent of the growth in local expenditures (almost all of which came from federal and state grants for relief purposes). Even more revealing are the figures for the period between 1932 and 1935: in those three years national government expenditures rose by slightly less than $2 billion, while expenditures for relief alone reached $2.2 billion in 1935 from zero in 1932. (1)

The increase in federal expenditures was significant, but an important reason why state and national governments grew, but local governments did not, lay in the fiscal structure of the relief programs. The extensive use of matching grants to finance relief expenditures created incentives for states to expand their fiscal effort, while local governments were effectively able to substitute national and state relief grants for their own funds. Matching grants also allowed the states to control the amount spent in each program. The national government was, and is still today, unable to control expenditures on these programs or to equalize welfare standards across states. Open-ended matching grants "entitled" the states to unencumbered access to the federal treasury. (2)

The programs also permanently altered the American welfare system. The categorical assistance programs of the Social Security Act brought about a basic realignment of financial and administrative responsibilities between the federal, state, and local governments. Old Age Assistance, Aid to Dependent Children, and Aid to the Blind were independently administered by state governments. The Act contained strong restrictions on the ability of the Social Security Board to influence the administration of programs within the states, explicitly forbidding the Board to set personnel policies. (3)

Why were open-ended matching grants and a decentralized administrative structure adopted rather than some other institutional form? Public finance theory suggests that it may have been the best way for the federal government to support relief expenditures without discouraging continued state and local participation. Matching grants are usually proposed as a remedy to problems of externalities. In this case the spillover is the movement of persons seeking relief from low-benefit to high-benefit states. They solve the externality problem through the use of fiscal incentives: as Gramlich [1977, 276] notes, "for [matching grants[ the central government is expressly trying to stimulate spending in a certain area." As we will see below, matching grants did have this effect: federal grants expanded rapidly, but the state and local sector did not substitute federal grant moneys for state and local tax dollars on a large scale. Recent empirical studies of matching grants indicate that they "result in somewhat less spending than the size of the grant" indicating that state and local governments reduce their own expenditures on grant programs slightly in the presence of matching grants, in contrast to lump sum grants where state and local governments are able to substitute significant amounts of federal grants for their own tax dollars. …

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