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date: 30 May 2020

(p. ix) Foreword

(p. ix) Foreword

While many citizens care deeply about the tax and spending policies in their own state or city, the general subject of state and local finance does not attract widespread public interest except in a crisis. Scholars of fiscal federalism rarely become media stars. Now, however, two such crises have converged to put state and local finance in the cross hairs and virtually guarantee that long-accepted policies will be reexamined by the federal government and state and local jurisdictions all over the country. The first is the Great Recession, which has undermined state and local revenues while at the same time increasing state and local expenditure responsibilities to a far greater extent than recent recessions. The other crisis is the unsustainable trajectory of federal debt. Absent substantial policy change, federal debt will grow faster than the economy in the years ahead even as the economy recovers. Some combination of reductions in projected federal spending and increases in revenues will be necessary for achieving federal financial stability, and both will put pressure on state and local finances for the foreseeable future. Will these two crises result in a weakening of state and local fiscal viability—fewer federal grants, more mandates, increasing federal preemption revenue sources, and a declining quality of services? Or will the stresses lead to a serious rethinking of federal, state, and local roles and finances that could strengthen the effectiveness of government? The chapters in this volume address these questions with short- as well as medium- and long-term perspective.

The Great Recession dramatized the vulnerability of states and localities to economic downturns as both the dependence on the income tax and other cyclically sensitive revenue sources increased along with their spending obligations. At the same time it showed how difficult it is for federal fiscal policy to stabilize the economy in the face of procyclical state and local spending cuts, as substantial amounts of federal stimulus were negated by fiscal drag from the state and local sector. The Great Recession further revealed the worrisome structural weakness in state and local finance as consumer spending shifted from goods to less easily taxed services, internet sales increased, and anti-tax sentiment capped revenues at unrealistic levels. These stresses might be forgotten—as they have been after past recessions—if the economy were soon to start growing robustly; but rapid recovery is highly unlikely in the face of the collapsed housing market and the federal debt crisis. Furthermore, the oncoming tsunami of retirees combined with relentless health care cost increases will continue to drive up spending for Medicare, Medicaid, and Social Security even if significant reforms reduce some of the currently projected growth in these programs. Federal revenues will have to rise to (p. x) offset part of the increasing federal debt, and interest rates are very likely to rise. All of these factors can be expected to lead to higher state and local borrowing costs, greater resistance to revenue increases, and a congressional proclivity to push the federal deficit “down,” through actions such as reducing federal grants to states and localities and adopting a policy of enacting costly unfunded expenditure mandates.

Efforts to deal with the looming federal debt have also revealed public ambivalence about federal spending and great confusion about the appropriate federal role. Politicians are often applauded when they deplore federal spending or Washington “overreach” in the abstract, but meet resistance if they propose specific cuts in spending large enough to make a dent in the total. Part of the problem is that federal spending programs have proliferated over the years in response to changing needs and pressure from particular interest groups. The public often does not have a clear idea what the federal government actually does, what specific activities accomplish, and what they cost. This is true not only in the domestic arena, but also with regard to national security, where changing threats have led to a costly legacy of outdated but well-entrenched programs and a public with little idea of how they contribute to security and at what cost. Federal budget numbers are all very large and confusing, so it is possible for wishful thinkers to harbor the hope that cutting our “waste and fraud” or “welfare” or “foreign aid” would reduce federal spending significantly and balance the budget without the necessity of touching well-beloved programs such as Social Security and Medicare or raising more revenues.

Over several decades many have argued for a sharper division between federal responsibilities and those of state and local government for clearer accountability (see, for example, Alice M. Rivlin, Reviving the American Dream; The Economy, the States, and the Federal Government, 1992). The federal government could retain clear responsibility for national security, foreign affairs, air traffic control, problems that move across state boundaries (air and water pollution), Social Security and health care financing, while devolving to the states and their localities functions that require adaptation to local conditions, citizen input, and community support. These include education, housing, most law enforcement and transportation, economic development, and social services. This sharper intergovernmental allocation of expenditure responsibilities and revenue authority would take some of the spending pressure off the federal taxpayer, as well as help citizens understand which type of government is required to do what and, thus, whom to hold accountable. It would also force politicians to explain their tax and spending proposals instead of talking vaguely about federal overreach and avoiding hard choices.

Recognizing the need to reinforce a cooperative federalism, new federal revenue structures could not only reduce federal debt and stabilize state and local revenues, but also reduce competitive state and local tax reductions ostensibly designed to attract business (the “race to the bottom”). For example, a national consumption tax, such as a value added tax, could be coordinated in a manner that would preserve state revenue autonomy as well as provide funds for reducing the (p. xi) inherent fiscal disparities among the states. A carbon tax shared with the states could create incentives to reduce greenhouse gases and raise revenue at the same time. A uniform shared corporate income tax base could generate new revenues, reduce tax gaming by multistate corporations, and lower the costs of taxpayer compliance and revenue administration.

As documented in this handbook, the Great Recession and its aftermath have been a shock to the public finances of federal and state and local governments alike. But, as history attests, the US system of fiscal federalism is one of proven resiliency that time and time again has been key to adjusting to such shocks and, thus, to the accomplishment of the nation's broader goals of financial soundness, growth, and stability and a return to fairness in the distribution of income and wealth. Despite all its very real and deep negative impacts, the Great Recession also brings with it an opportunity to act wisely. Many innovations in fiscal federalism are possible. However, retaining many of the current practices of how we tax and spend and the division of responsibilities and tax structures in the face of recurring crises is a bad option. Refusing to act will guarantee continuing confusion over governmental roles and deteriorating government services.

Written for practitioners and scholars alike, this handbook provides a comprehensive and timely knowledge base of the trends in and current status of the nation's intergovernmental and financial arrangements and the policy and practice of US state and local finance. It also identifies options for policy and administrative changes that range from adjustments to specific programs and tax structures to a broad rethinking of how the public finance systems can help fulfill the American dream of an economy that is both just and productive. The messages here are of optimism as well as of urgency to act. The optimism stems from the proposition that a well-informed democratic political system can produce fair and efficent fiscal systems that people can understand and will support. The second message is that now is the time to institute fiscal policies that will require making the difficult but necessary choices that will revitalize and rationalize how the United States' public sector is financed.

Alice M. Rivlin

The Brookings Institution and Georgetown University

Co-Chair, Debt Reduction Task Force, Bipartisan Policy Center

November 2011 (p. xii)