Rich states, poor states

End the inequities in state public finance

 
 

Economic development policy cannot be divorced from issues of public finance. When a state or region starts doing well, tax revenues pour in. This enables the provision of new incentives for firms and public services for residents, making the region all the more attractive. The resulting feedback loop can turn a local economy around, but it can also work in reverse. Regions that are doing poorly may have to raise taxes or cut programs to maintain balanced budgets, creating further reasons for businesses and residents to leave. When these virtuous and vicious cycles work in tandem, the gap between haves and have-nots pulls farther apart.

Niskanen Center senior fellow Joshua McCabe argues that solving this inequity will require reforms to our system of fiscal federalism. In other large, regionally diverse countries like Canada and Australia, national governments correct for the diverging fiscal capacities of subnational governments with transfers and block grants. The primary tool for doing this in the United States is known as the Federal Medical Assistance Percentage, or FMAP formula.

When states provide programs with federal matching funds, the FMAP formula ensures poorer states receive more resources. Yet because the minimum federal match is pegged at 50 percent by law (or 90 percent in the case of the Medicaid expansion), states receive large federal payments even if they have a wealthy tax base of their own. As a result, a poor state like Mississippi only has a fraction of the resources to provide public goods as a rich state like Massachusetts, despite having double the poverty rate and half the per-capita income.

Our broken system of fiscal federalism is unfair to the residents of poor states, but it also has important implications for their development. With tighter budgets, poor states can do less to invest in human capital and infrastructure, slowing their convergence with rich states. The past thirty years have seen a dramatic decline in the rate of income convergence across states. Research suggests historical differences in the fiscal capacity of states is one reason. The Niskanen Center’s Struggling Regions Initiative is thinking through reforms to state and federal systems of public finance to rectify this imbalance.

 
 

Federalism in the Blue and Red

Joshua T. McCabe

National Affairs | Summer, 2017