Fiscal Federalism: Spending and Taxes

Fiscal Federalism: Spending and Taxes

The modern communities strive to develop and offer increased living standards for their population. In doing so, they collaborate closely with the state and federal institutions, which send them part of the required funds. "The federal government transfers about one fourth of its revenues to the states, which in turn disburse important operating funds to cities and counties. State governments play a major role in funding local governments - including counties, municipalities, and school districts - for education, transportation, public health and social services. When tough economic times depress revenues at the top, jurisdictions at the bottom bear the burden" (Ruben, McGuire and Kellam, 2007).

However, there are situations in which these funds are insufficient - a relevant exemplification of this scenario was offered by the 2001 economic recession. The measures to be implemented in such instances depended on the relations policies favoured by each institution. Otherwise put, there are two alternatives: the federal institution could increase the fund of the state one and the state institution could consequently increase the funds of the local agencies. Despite the favourable feedback retrieved for the implementation of such a measure, fact remains that unconditional aid systems pose severe disadvantages on both institutions and communities. The aim of this paper is to present some of these reasons which make Federal-State and State-local unconditional aid systems an undesirable solution.

Unconditional Aid Systems

Unconditional aid systems, or General Revenue Sharing (GRS) refer to funds which are accessible to all institutions in a jurisdictions. In a more simplistic formulation, they imply the idea that hierarchically superior organizations will allow more funds to the hierarchically inferior institutions, in order to support their state or local projects.

The idea was first implemented in 1972 by U.S. President Richard Nixon, who found the system to be the most efficient solution to the problems encountered by federal institutions. He described it in terms of "a new American revolution - a peaceful revolution in which power [is] turned back to the people...a revolution as profound, as far-reaching, as exciting as that first revolution almost 200 years ago" (Wooley and Peters, 1999). His successor, Gerald R. Ford shared similar views relative to the usefulness of the General Revenue Sharing systems. Foremost, three years after the initiation of the agenda, President Ford desired to expand it and implemented the following:

Retention of the basic revenue sharing formula now in use

Authorization of funds for another five and three-quarters years

Continuation of the current level and method of funding, with annual increases of $150 million

Increased public participation in determining the use of shared revenues

Improved enforcement of the civil rights provisions to insure that revenue sharing funds are not used in a discriminatory manner" (Gerald R. Ford Presidential Library and Museum, 2006)

The system worked on two paths: federal to state governments and state governments to local governments. Despite the positive feedback it has historically retrieved, the unconditional aid system is no longer as popular as it used to be. As such, the federal government refused its implementation and today, only few states still use to transfer funds to their local subsidies.

Case against Unconditional Aid Systems

Another argument in detriment of unconditional aid systems is the fact that, just like any other entity, the federal and state institutions govern themselves. This means that they cannot ask for more money and they have to make do with what they have collected through a fiscal year. This then means that their investment capabilities are rather limited. In this order of ideas then, for a federal or state institution to offer unconditional financial aid to its state or local subunits, would imply that the institutions' funds for investment and improvement decrease. Consequently, the larger units are no longer able to increase the quality of the schooling or educational systems. They are also insufficiently funded to build new houses or improve the quality of the roads or the infrastructure. Ultimately then, the offering of unconditional aid systems would generate negative impacts upon the population, who would be unable to benefit from their contributions.

Aside from the dissatisfaction generated upon the citizens, the offering of unconditional aid systems should also be limited, if not at all eliminated, due to the complex nature of state and federal investments. These are often expensive and a return on investments is only viewable in some years' time. Foremost, when they occur, they generate massive financial setbacks for the institution implementing them as they generally require a large sum of money. "It is difficult to properly handle investments in public budgets. The rewards are spread out over an extended period of time while the cost or the pain of investing is immediate. That makes if difficult to finance public investments" (Penner, 2008).

For the state and local governments to be able to fund their investments, they should organize their incomes into two categories: current operating capital and capital component. A simple accounting method would help them benefit immediately from the investment. In this order of ideas, given that the investment is amortized and the amortization is registered as part of operating expenses, the users of the investments would immediately benefit from it, and also pay it at the same time (Penner, 2008).

Another means to deal with the upcoming investments or the financial coverage of other needs likely to emerge should revolve around the constitution of rainy days funds. These would allow each state institution to govern itself in an efficient manner and are even more so worthy as they have saved several state institutions throughout the 2001 economic recession (Ruben, McGuire and Kellam, 2007). They are also referred to as budget stabilization and are constituted from funds which "allow states to set aside excess revenue for use in times of unexpected revenue shortfall of budget deficit" (Rueben and Rosenberg, 2008). The amount of rainy day funds each institution allocates depends on various features. In 2007 for instance, rainy day funds accounted for 1% of all institutional funds in Michigan and Wisconsin, 20% in North Dakota and 50% in Alaska. The other states found their rainy day funds somewhere between the extremes of 1% and 50% of total funds.

Unconditioned aid systems should not be implemented in order to stimulate state and local institutions to govern themselves with the taxes collected throughout a fiscal year. If the government constantly steps in and resolves the financial shortages of a state organization, that respective institution will never learn how to properly administrate their funds, assets and debts.