Federalism’s Downside

Pietro S. Nivola
Pietro Nivola
Pietro S. Nivola Former Brookings Expert

February 16, 2012

Washington, writes Bruce Katz, “is mired in gridlock.” One could quibble over how “gridlocked” Washington actually has been. For all the partisan acrimony of recent decades, the central government still has managed to enact national health care legislation that has eluded past presidents, a torrent of fiscal stimulus, a far-reaching overhaul of financial regulation, a massive expansion of Medicare, comprehensive welfare reform, a huge new cabinet department, and a series of deep tax cuts—while, for good measure, waging two wars. Isn’t such a government, in fact, quite active, and perhaps overextended?

Nonetheless, Katz has a point. Much novel policy, indeed leadership, has emanated from statehouses in recent times, a prime example being the path-breaking health insurance law of Massachusetts, as he notes. Or consider the world-class environmental standards set by California, the job-creation performance of Texas, or the public-employee pension and compensation reforms in New Jersey.

Katz makes a case for leveraging “the distinctive assets and advantages” of American federalism, particularly the entrepreneurial energy for economic development that often bubbles up from states and localities. What are those assets and advantages?

The main one, in my judgment, is what public finance economists call the practice of fiscal equivalence. In the United States, unlike the unitary regimes of other advanced countries, local taxpayers have to pay directly for most of the services they consume. Of course, Washington’s intergovernmental grants and transfers also account for a significant share of the resources available to states and cities. Yet even in comparison with other federations (such as Germany), the local needs or demands of citizens here still have to be met primarily through own-source revenues.

In principle, this arrangement facilitates fiscal discipline and local creativity. If a state or municipality wants better schools, roads, or social services, its residents—not some distant group or entity—have to pay the piper for the most part. To defray its expenses, the municipality or state has to compete to retain or attract taxpaying businesses and households.

The interjurisdictional competition for jobs and wealth is often efficient. It spurs communities to experiment with public investments, regulatory policies, and safety nets that won’t impair the local economy and hence will ultimately bolster the local tax base. Because people and firms can “vote with their feet,” jurisdictions may have a keen incentive to innovate creatively and, in fiscal terms, not get too far out of line by embracing profligate agendas. The resulting local experimentation may eventually redound to the benefit of society as a whole. When contemplating new programs, policymakers at the national level presumably tend to learn “what works” from projects first field-tested in the states.

All this, in theory, is the good news about the nation’s federated republic. And, as Katz suggests, in a number of places and for a good deal of the time, its virtues are in evidence. The form of federalism in this country arguably does discourage the growth of a bloated public sector that overtaxes and overregulates. For all the excesses of some spendthrift state governments, to date none is comparable to Greece. In short, the comparatively decentralized U.S. system helps explain why the government remains a bit less “big” and less unsustainable in the United States than, say, in much of Europe.

But there is also bad news about American federalism’s distinctive institutions, and it is a partial but pertinent counterweight to Katz’s perspective. The economic crisis of the past few years serves as a painful reminder that a prime responsibility of any modern government is to carry out antirecessionary measures, and to do so promptly, comprehensively, and effectively when a sharp downturn looms. Alas, this is where America’s two-tiered public sector, roughly half of which rests at the state and local level, greatly complicates matters. Therein, what may be virtuous constraints in normal times—chiefly, the norms of extensive fiscal equivalence and of balanced-budget requirements in nearly every state—turn out to be liabilities in a severe economic slump. Why? Because they beget pro-cyclical policies that partly neutralize the countercyclical efforts of central authorities. So while Congress may succeed in enacting an $800 billion stimulus package, for example, and the Federal Reserve duly pursues monetary expansion, state and local governments have a tendency to move in the opposite direction: scrambling to meet revenue shortfalls, they cut budgets and raise taxes.

This perverse intergovernmental dynamic—with states effectively taking money out of people’s pockets as Washington tries to put more in—may help explain why tepid GDP growth and high unemployment have persisted for almost three years since the official end of the Great Recession. Of all the challenges federalism is likely to bestow on future administrations, this is the most vexing. Presidential candidates ought to grapple with it. The U.S. economy is not entirely out of the woods. Its recovery remains vulnerable, and another downturn within the next four years cannot be ruled out. Some form of contingent countercyclical revenue sharing may need to be readied beforehand.

Designing a sound program will not be easy, not least because a moral hazard arises if states can simply expect a federal bailout during recessions. A judicious partnership between the levels of government could include some of the microeconomic initiatives Katz envisions, but in the next presidential term the partnership will also require more macroeconomic coordination—including better inducements for states in good times to prepare for eventual rainy days.