Fiscal Federalism
What is Fiscal Federalism?
Fiscal federalism is the division of taxing and spending powers among national, state and local governments, and the transfers that flow between them.
The general rule is that services whose benefits stay local, such as street lighting and schools, are best run locally, while functions with national reach, such as defense and macroeconomic stabilization, belong to the central government. Local governments face a harder financing problem because residents and businesses can move to avoid taxes, so redistribution at the local level tends to fail. Central governments therefore collect the most mobile tax bases and send money down through grants, which may be block grants with few strings or categorical grants tied to a purpose. Matching grants change the local price of a service and so change behavior, while lump-sum grants mainly change spending power.
Fiscal Federalism: a worked example
A federal matching grant that pays $1 for every $1 a state spends on transit halves the price the state faces, so a $40 million state budget line now buys $80 million of service. If the state instead receives a $40 million lump sum with no strings, transit spending usually rises by much less, because the money can substitute for funds the state was already going to spend. Economists call the tendency for grant money to stick where it lands, rather than being passed through as tax cuts, the flypaper effect.
The mistake students make with fiscal federalism
Students assume fiscal federalism just means the national government sends money to states. The term covers the whole assignment of functions and revenue sources across levels, including which level should tax what. A second error is treating all grants alike. A matching grant lowers the price of the service and encourages more of it, while a lump-sum grant raises income without changing relative prices, so the two produce different spending responses.
Fiscal Federalism questions
Why is redistribution handled by national rather than local governments?
Redistribution works poorly at the local level because people and firms can move, so a generous local program attracts recipients and drives away the taxpayers funding it. National governments face far less mobility across their borders, which makes a redistributive tax and transfer system sustainable. This is the standard argument for assigning redistribution and stabilization to the center.
What is the difference between a block grant and a categorical grant?
A block grant gives a lower level of government money for a broad area with wide discretion, while a categorical grant restricts the money to a specific program and often attaches conditions. Block grants let local officials match local preferences; categorical grants let the center pursue national goals. Matching provisions can be attached to either and change the recipient's incentives most.
Why do local governments rely on property taxes?
Local governments lean on property taxes because land and buildings cannot move away in response to the tax, which makes the base stable and hard to avoid. Mobile bases like corporate profits or high incomes are better collected at the national level. The trade-off is that property tax revenue tracks local property wealth, so school funding can vary sharply between districts.
Related terms
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