FEDERAL ASSISTANCE TO STATE AND

LOCAL GOVERNMENTS

I. Introduction and Summary

While the Federal Government has maintained a roughly constant 20 percent share of GNP in the postwar period, State and local governments have increased their share significantly from 5.3 percent of GNP in 1946 to 15.3 percent in 1975. An important source of support for this growth has been increasing Federal grants-in-aid, which have grown as a proportion of both Federal and State and local expenditures. Such grants, currently over 600 in number and $60 billion in dollar amount, and present in virtually every function, reflect the greatly increasing scale and complexity of Federal-Statelocal fiscal and administrative relationships.

Fiscal year 1977 presents a significant decision point with respect to those relationships. The combination of expiring existing legislation, major Presidential proposals, and significant Congressional initiatives gives the fiscal year 1977 budget a potentially key role in defining the future mix of funding and spending responsibilities among Federal, State and local governments.

EXPIRING LEGISLATION

General revenue sharing, which reaches the end of its initial 5-year funding period on December 31, 1976, and the Law Enforcement Assistance Administration, a Johnson-era block grant which has been renewed with modifications twice and currently expires on September 30, 1976, are both up for renewal. The President has recommended extension of both, for 5 and three-quarters and 5 years, respectively, with funding levels somewhat below those provided by current policy.1

PRESIDENTIAL PROPOSALS

The President proposes to consolidate 59 categorical grants into four block grants in the areas of health, education, social services, and child nutrition, and to phase out 270,000 CETA public service jobs administered by States and local governments. Spending reductions connected with these and other Presidential recommendations would reduce total grants to State and local governments by 13 percent below current policy level, and cut the dollar amount of aid ($60.5 billion) below that provided in fiscal year 1976 ($62.9 billion under current policy).

1 Current policy is the level of real spending consistent with the Congress' Second Concurrent Resolution on the Budget for fiscal year 1976.

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CONGRESSIONAL INITIATIVES

The Public Works Employment Act of 1975, vetoed by the President and due for Congressional reconsideration, contains innovative proposals for countercyclical financial assistance to State and local government. At proposed annual funding levels of $500 million plus $250 million for each one-half percentage point of national unemployment above 6 percent, countercyclical assistance would pay out $1 billion in fiscal year 1977 if unemployment averaged 7 percent over the year. The Congress is also considering substitutes for the exclusion from Federal income taxation of interest on municipal bonds.

This paper is an effort to put these individual budget decisions in the broad context of evolving Federal-State-local fiscal and administrative relationships. The next section provides background information on existing State-local grant programs and on the President's fiscal year 1977 grant proposals. Section III discusses objectives of Federal grants-in-aid, and arguments for and against different objectives and techniques. Section IV presents individual fiscal year 1977 spending issues in some detail. The concluding section explores several possible future directions for Federal-State-local fiscal and administrative relations, and the sets of fiscal year 1977 spending decisions which correspond to each. Directions considered are (1) continue the growth of Federal grants to State and local governments, although perhaps not at recently experienced rates, without major change in the mix or structure of grants; (2) continue the trend toward reduced Federal control over use of grant moneys through adoption of general revenue sharing and block grants, and aim for reductions in grants, or stabilization at existing dollar levels, either now or in the future as a result of greater State-local spending flexibility; and (3) reduce general and some categorical support for State and local governments and federalize key national services to which those governments presently contribute. The conclusion is that spending decisions consistent with any of these directions can be made this year, and that the availability of countercyclical assistance provides the flexibility to move in desired directions without being inhibited by the current recessioninduced strains on State-local budgets or getting locked into unwanted permanent funding commitments. Countercyclical assistance also enhances national economic recovery by providing coordinated built-in stabilization across the public sector.

II. Current Programs and the President's Proposals

CURRENT PROGRAMS

The estimated outlays of $62.9 billion for State-local aid in fiscal 1976 represent an increase in numbers of programs as well as in budgetary significance over the last decade. În 1966 there were fewer than 350 programs with outlays of $13 billion, comprising 9.6 percent

2 Countercyclical assistance has recently repassed the Senate as part of S. 3201 the Public Works Employment Act of 1976. This new legislation provides the same amount of assistance as the earlier bill, but utilizes a more sensitive triggering mechanism and spreads the money more broadly.

of the Federal budget. If current policy levels are maintained, outlays in Federal grant programs will be $69.8 billion in fiscal year 1977, or 16.8 percent of total Federal spending (see Table 1). While Federal grants have been increasing as a proportion of both Federal and State and local outlays, Federal control over the use of grant funds has been declining due to introduction of general revenue sharing and shifts from categorical to block grants. Categorical grants comprised 98 percent of Federal assistance in 1966; by 1976 the proportion had dropped to 76 percent.

Table 1.-FEDERAL GRANTS TO STATE AND LOCAL GOVERNMENTS

State governments receive more direct Federal grant funds than local governments, although their share has declined from 88 percent in 1969 to 76 percent in 1974. The increase in the share of local governments is largely attributable to the $4 billion per year they receive from revenue sharing. However, State governments redistribute a portion of their Federal grant funds to local governments. Since no data are available on the extent of these pass-throughs, a precise determination of the ultimate distribution of Federal funds is not possible.

In two important grant programs, Medicaid and AFDC, the grant funds are in essence passed through to individuals. In other grant programs, funds are spent by recipient governments to provide services; for example, schooling, day care, highways and law enforcement. In many cases, State and local governments are required to contribute matching funds to the federally supported activities.

The percentage of total Federal outlays in each budget function accounted for by grant programs is shown in the first three columns of Table 2.

The distribution of total Federal aid among the several functions is exhibited in the second three columns of Table 2. In 1974, income security, and education, employment training, and social services received the most grant funding. However, the relative importance of these functions, as well as of commerce and transportation, has decreased over time. The shift toward general purpose aid is shown by the increasing share of total grant outlays found in the revenue sharing function.

Source: Office of Management and Budget, Federal Government Finances (supplemental material to fiscal year 1977 Budget).

In addition to Federal budget outlays under grant programs, State and local governments are assisted by Federal tax espenditures. Major items are detailed in Table 3. All of the tax expenditure items provide assistance of a general nature to State and local governments. The bond interest exclusion allows State and local governments to borrow at lower interest rates, but the resulting savings to them are less than the revenue lost by the Federal Government. The reduction for State and local taxes allows State and local governments to raise revenues without raising net tax burdens by an equivalent amount.

Table 3.-COST OF MAJOR FEDERAL TAX EXPENDITURES AIDING STATE AND LOCAL GOVERNMENTS, FISCAL YEARS 1967 AND 1976

Deductability of nonbusiness State and local taxes (other than on owner-occupied housing).

"Deductability of property taxes on owner-occupied homes_

Finally, State and local budget positions are affected crucially by general economic conditions and thus by the degree of overall stimulus or restraint which Federal policy chooses to apply to the economy. Each extra percentage point of unemployment above full employment creates a $6 billion gap between State and local income and outlays, as tax revenues fall off from anticipated levels with reduced economic activity and demands for public services on the part of unemployed and other financially strapped people increase. Inflationary bursts also strain State and local government budgets, since they tend to increase interest costs, wage and salary demands of personnel, and prices of purchased goods more than they do revenues.

THE PRESIDENT'S BUDGET

The President's fiscal year 1977 proposals for aid to State and local governments would reduce both Federal spending and Federal control. Proposed grant outlay totals are $60.5 billion, or about 13 percent below current policy budget estimates. Table 4 contrasts the President's recommendations with current policy by function, with proposed grant consolidations shown in parentheses. Consolidations account for approximately 40 percent of cutbacks recommended by the President. However, most of the other proposed cutbacks come from the same human resources areas. Key reductions are as follows: -$1.6 billion in community and regional development, where the President omits outlays expected as a result of the Public Works Employment Act of 1976.

-$4.6 billion in education, training, employment, and social services, where the President plans reductions in public service employment and education. The implications of his jobs proposals are discussed in a companion paper on employment.

-$1.7 billion in health, where funding proposed for the Financial Assistance for Health Care Act is less than current policy estimates for the replaced categorical programs, including Medicaid.

-$1.0 billion for income security, where the proposed child nutrition block grant is confined to poor children.

The President's block grant proposals would reduce Federal control over State and local programs. Recipient governments would be freer to allocate funds to their own high priority uses, and the proposed elimination of matching requirements in many programs would further increase State-local discretion over their spending and taxing patterns. This greater flexibility could mean efficiencies in the provision of State local services and thus a reduced need for Federal grant support. It could also mean abandonment by States and localities of programs which the Federal Government initiated and previously supported.