Study Finds Federal Grants Lead to Increased State Taxes

Dependence on federal aid places state revenue in precarious position

By Daniel M. Rothschild

With federal grants to states increasing by 73 percent over the last decade and totaling $654 billion in 2010, governors and legislatures are grateful for federal assistance in plugging budget gaps.

They may rethink their decisions in the coming years; however, as they begin raising taxes when federal largesse dries up.

According to a new study from the Mercatus Center at George Mason University by economists Russell Sobel and George Crowley, federal aid to states prompts future state tax increases of between 33 and 42 cents for each federal aid dollar, with local governments raising taxes and fees by an additional 23 to 46 cents.

All told, Sobel and Crowley estimate that state and local governments will increase their taxes by around $80 billion in the future as a result of the federal stimulus.

“Legislators need to know that when they agree to accept federal grants, they’re also agreeing to raise their citizens’ taxes later,” said Sobel. “This isn’t free money with no strings attached; it completely changes the way that states budget.”

Economists have long suggested the existence of a “flypaper effect,” wherein federal money given to the states prompts additional spending. Sobel and Crowley’s paper is the first to demonstrate that federal money promotes future tax hikes.

They explain that when temporary federal aid to states is used to pay for recurring expenditures, state and local governments raise taxes and fees to pay for these expenses when federal money stops. As an example, Sobel and Crowley cite West Virginia University’s location, Morgantown, which was given a federal grant to hire two additional police officers for three years. When the federal aid stops, the city is unlikely to lay off these officers and will instead seek local revenues to pay for the positions.

“As Milton Friedman quipped, there’s nothing as permanent as a temporary government program,” said Sobel. “Many of the so-called temporary grants the federal government is distributing today will likely result in significant state and local tax hikes in the future.”

Economist Eileen Norcross, who studies state and local government finance, stresses the importance of Sobel and Crowley’s findings.

“Most states are playing games with their budgets,” said Norcross. “By closing budget gaps with federal aid today, they are almost guaranteeing higher spending, higher taxes, and greater fiscal instability down the road.”

Daniel Rothschild is a Visiting Adjunct Scholar with the Pelican Institute for Public Policy and the Managing Director of the Mercatus Center’s State and Local Policy Project at George Mason University.