The recession of 2007 is perhaps the deepest, longest, and most damaging economic event of the last 75 years. In response, all tools of macroeconomic policy management were called into use: from direct easing of interest rates and purchasing of public and private debt to tax cuts and government spending. There is every reason to think that this across-the-line defence was necessary to prevent a major recession from turning into what might have been a worldwide depression.
But not all tools in the arsenal were effective as protection against the downturn, and one in particular – national government transfers to state governments in federal economies – may lead to more long-run harm than short-term benefits.
Why fiscal stimulus is usually done centrally
In open economies with federal systems of government, state or provincial governments have little incentive to actively pursue fiscal policies for macro stability. Any state that does attempt to stimulate its local economy with cut taxes and spending rises will, by virtue of free trade within the nation, share any resulting expanded demand for goods and services with producers in all other states. Whatever labour demand expansion that does occur locally can be undone by the inflow of workers from other states. In the meantime, the local authority is left with higher debt due to the deficit financing.
Thus while state residents incur the costs of local debts, the nation as a whole is likely to enjoy most of the expansionary benefits of the state’s deficits. In open economies, local macro fiscal policy provides positive spillovers creating incentives for states to under-provide needed stimulus. For this reason, macro fiscal policy should be done centrally.
Central government fiscal stimulus
Central government fiscal policies for stimulating the private economy can come either as a cut in taxation or as an expansion in government spending. The micro-economic evidence suggests unexpected infrastructure spending (Ramey Forthcoming) and unexpected tax cuts, or expanded transfers to lower income, credit-constrained households (Johnson et al. 2006) are the most effective fiscal tools for a quick stimulus to aggregate demand. More aggregate evidence from the work of Blanchard and Perotti (2002) and Romer and Romer (2010) shows that such fiscal policies can be effective sources of new demand for a lagging macro economy.
In most federal economies, however, the central government relies upon states to spend their money as state governments are thought to be the relatively more efficient provider of most public services. Inside the nation, inter-state fiscal competition also encourages production and tax efficiencies and, through sorting, a better match of services levels to the needs of households and firms.
When there are inter-state tax or service spillovers, central government financing through inter-governmental grants can solve the problem; service provision can and should remain local. Oates (1999) provides a valuable summary of the arguments and the evidence.
Virtue turns to vice in recessions
The virtue of decentralised provision has the potential to become a vice in times of deep recessions, however. In federal economies, the central government may decide expansionary spending policies, but state governments have in place the institutional structures needed to best implement those policies. States are the ones who contract to build roads and who write unemployment and income support checks. In federal economies, states are the “agents” of the central government for much of spending policy.
Like any agent, however, states have their own agendas, and the available evidence suggests there is often a disconnect between central government intentions and state government responses.
This is particularly so when the intention is aggregate demand stimulation that are likely to accrue primarily to residents outside a state. Edward Gramlich (1978), for example, studied the response of states to a national effort to stimulate state spending during the 1975 US recession and found that states saved much of their stimulus money for spending at a later date – after the national economy had recovered.
Similarly, state policies towards lower income residents will be decided by politics dominated in most states by middle income voters. Poor households meant to receive extra federal assistance during deep recessions may not receive all the initially assigned federal money. This is why federal grants typically contain “maintenance-of-effort” provisions. But such requirements are hard to enforce. Most budget money is “fungible,” easily moved from category to category, so that federal aid simply replaces state money previously intended for the federal initiative.
New research on the multiplier for federal transfers to states
My recent work with Gerald Carlino (2010) using data to 2008 confirms Gramlich’s results. We extend the analysis of Blanchard and Perotti to explicitly allow for federal transfers to state and local governments. (They included such transfers as part of household income assuming that state governments are perfect agents for their residents.) When separated out, we find an income multiplier for federal transfers to states of only 40 cents for each dollar of federal aid even after 20 quarters. This income multiplier is significantly smaller than that found by Blanchard and Perotti and Romer and Romer for direct federal spending and tax relief.
There is a further complication. National policy, presumably decided by the principal in the national interest, requires the approval of the agents who are to implement that policy. To implement beneficial fiscal policy, a president will typically need the approval of the elected representatives from a majority of states. If so, spending policies that might make the most sense for a fiscal stimulus – say targeted infrastructure spending and poverty and unemployment assistance to areas most in need – can get diluted so as to satisfy the local needs of a majority of states.
Problems with the American Recovery and Reinvestment Act
Unless there are strong political parties under the control of the president, fiscal policy can become a hodgepodge of favoured programmes stapled together to win the needed votes (see Inman and Fitts 1990). This is what happened to President Obama’s fiscal stimulus package known as the American Recovery and Reinvestment Act (ARRA).
ARRA was approved in February 2009. Designed to stimulate the national economy and to provide budget protection for state services, the legislation included $223 billion in intergovernmental grants for spending by the US states. (ARRA also included $292 billion in federal tax cuts and $272 billion in direct federal spending which are not at issue here.) The research of Gramlich and my more recent work with Carlino noted above suggests this spending will have only modest effects in stimulating the macro-economy.
What about ARRA’s ability to protect the level of state services? Is this an argument for assistance? My analysis (Inman 2010) shows that ARRA’s assistance was largely distributed as a per capita transfer. Projected fiscal deficits did lead to more assistance, but ARRA covered at most $0.25 of each dollar of projected state budgetary shortfalls. The other important determinant of ARRA funding was whether the state’s Senators had membership on an important congressional committee making fiscal policy. Controlling for state population, deficits, and committee membership, the state’s rate of unemployment at the time of passage had no statistically significant impact on the level of assistance.
Lessons from the American Recovery and Reinvestment Act
It is hard to argue from available evidence that the states’ share of ARRA funding met its presumed objectives. On the downside, the political process that approves such funding appears to generate perverse incentives for efficient state budgeting in the long-run. Worthy candidates for aid, those managing balanced budgets in the face of high unemployment, got significantly less assistance than the average state. Congress recently approved an additional $26 billion in “fungible” aid for state governments with the same votes as originally approved ARRA.
The US experience clarifies all the difficulties of managing fiscal policy for macro-stability in open federal economies. Many small states, whether by geography or market size, will be unable to run effective stimulus policies. This is the job of the central government. But for the same reason we have states as fiscal agents in the first place, the central government needs states to spend money in times of deep recessions. If it does so through intergovernmental transfers, states will pursue their own agendas with such assistance and that agenda typically will not be directed at stimulating the local, and therefore the overall, economy. Coupled with the fact that in federal democracies, the states themselves must often approve these transfers, further twists the allocation away from a targeted and effective spending stimulus.
From the US record at least, using states for macro-policy offers little in the way of short-run benefits and seems likely to create perverse incentives for state budgeting in the longer run.
Blanchard, Olivier and Roberto Perotti (2002), “An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output”, Quarterly Journal of Economics, 117 (November):1329-1368.
Carlino, Gerald and Robert Inman (2010), “Using States for Macro Policy: The US Experience,” Draft, Federal Reserve Bank of Philadelphia.
Gramlich, Edward (1978), “State and Local Budgets the Day After It Rained: Why Is The Surplus So High?” Brookings Papers on Economic Activity, 1:191-216.
Inman, Robert and Michael Fitts (1990), “Political Institutions and Fiscal Policy: Evidence from the US Historical Record", Journal of Law, Economics and Organizations, 6 (December):79-132.
Inman, Robert (2010), “States in Fiscal Distress”, Federal Reserve Bank of St. Louis, Regional Economic Development, 6(1), forthcoming.
Johnson, David, Jonathan Parker, and Nicholas Souleles (2206), “Household Expenditure and Income Tax Rebates of 2001”, American Economic Review, 96 (December):1589-1610.
Oates, Wallace (1999), “Essay on Fiscal Federalism”, Journal of Economic Literature, 37 (September):1120-1149.
Ramey, Valerie, Forthcoming, “Identifying Government Spending Shocks: It’s All in the Timing,” Quarterly Journal of Economics.
Romer, Christina and David Romer (2010), “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks”, American Economic Review, 100(June):763-801.