Federal Aid to States Creates Pervese Incentives, Undermines Federalism

The Mercatus Center has a new policy report on the perverse incentives of the stimulus – i.e. that it drives state governments to spend more. Click here for the full report in PDF.

In part intended to help states confront looming budget shortfalls, the ARRA has done little to address the underlying causes, and has created perverse incentives that prevent the states from being fiscally responsible. At least 41 states and the District of Columbia have reduced public services, and 30 states have raised taxes. As of this writing, at least 42 states still face unresolved budget shortfalls.

Specifically, they outline three problems with the stimulus as a bailout to state governments. It creates “moral hazard” – rewarding states for fiscal malfeasance. It “masks underlying structural budget programs”; for example, Pennsylvania lawmakers took a reprieve from fixing long-term problems with Medicaid, pensions, or unemployment insurance. And it undermines federalism by “increasing federal control over state budgets.”

On the latter point, Tad Dehaven posts on the incredible growth in federal aid to state and local governments over at Downsizing Government. Shockingly, federal aid (adjusted for inflation) increased a whopping 1,173% since 1960. He also points to a good essay on fiscal federalism.